Discover the Power of Compound Interest in Savings
Compound interest helps your savings grow quicker.
Ever heard the expression “money doesn’t grow on trees”? While that’s true, compound interest may make that dream a little more realistic.
Compound interest helps your account balance grow over time. This is good news when it comes to your savings account because it means your money could grow exponentially.
Let’s take a look at how compound interest works, its benefits, and how you could take advantage of it.
Compound interest earns interest on both the principal balance and previously accrued interest.
Compound interest is common for savings accounts and investment accounts.
The longer you keep your money in an account, the more compound interest it may earn.
What Is Compound Interest?
Compounding is the way interest is calculated for many savings products. Compound interest accrues not only on the principal balance, but also on the previously earned interest in the account. Essentially, you’re earning “interest on interest” each period… and that becomes the power of compounding.1
Time makes compounding even more fun because, each time the calculation compounds, there is an acceleration. So when it’s your money, the more time the money is in the account, the more interest it may earn exponentially.
Compound Interest Periods
The rate that your money grows at depends on the account’s compounding frequency. Many accounts compound interest daily, but some compound monthly or annually which may result in lower returns because that interest-on-interest calculation occurs less often.
Here are the most common compounding frequencies:
Standard Compounding Schedule
Savings and money market accounts
Daily or monthly2
Certificates of deposit
Daily or monthly3
Semi-annually (every 6 months)4
A consideration to keep in mind when choosing an account is the interest’s posting frequency as it impacts when you’re able to access the accrued interest. For example, an account may compound interest daily but only post the interest monthly. This means you wouldn’t have access to the accrued interest until it’s posted each month.
How Does Compound Interest Work?
As mentioned earlier, compound interest earns interest on both the principal balance and the interest accrued. The compounding frequency also plays a factor in how much your balance may grow.
There is a formula to calculate compound interest, but it’s a little complicated. A compound interest calculator is a quicker way to find the answer.
Compound Interest at Work
To understand how compound interest works, let’s look at two examples. Quick reminder - savings products express rates as Annual Percentage Yield (APY) which factors in the benefit of compounding.
Let’s say you have a savings account with a balance of $20,000 and a rate of 5.00% APY compounded daily. For this example, we’re assuming a steady APY and no deposits or withdrawals to the account.
In the first month, the account would earn about $83.17 in interest.5 This would be added to the initial balance of the account, bringing the total balance to $20,083.17. Interest would then accrue on the new balance for the next month and then be added to the balance again. This pattern continues indefinitely until the account is closed.
With this rate, your account would earn about $1,025.35 in interest6 in one year, resulting in a balance of $21,025.35.
Retirement accounts also utilize compound interest via investments and express these earnings as annual rates of return. For this example, let’s say you earn $150,000 per year and open a retirement account when you’re 25.
You initially invest $10,000 in the account and make yearly contributions of $10,000. For this example, we’re assuming the account earns a consistent annualized rate of return of 7.00% and you don’t make any withdrawals until you retire at 65.
When you turn 65, the account would have a balance of approximately $1,006,500.
Compound Interest vs. Simple Interest
Compound interest isn’t the only type of interest you encounter in finances. Another common type is simple interest, but you rarely see it with savings products.
Simple interest doesn't consider previously accrued interest in its calculation, only the principal amount. Basically, the simple interest calculation is what you learned in elementary school math.
Some products that tend to use simple interest include:7
Some certificates of deposit
Simple interest works in your favor when you’re borrowing money because you don’t have to pay interest on interest, which may reduce the overall cost of your debt. On the other hand, compound interest works in your favor when growing your savings because of the growth potential. No surprise – exponential growth with your savings is fun!
Pros and Cons of Compound Interest in Savings
Now that we understand how compound interest works, let’s look at ways it may help you achieve financial wellness.
There are a few main benefits to compound interest when it comes to growing and protecting your wealth.
Build long-term wealth: The primary way compound interest benefits your finances is by increasing your savings over time. The longer you leave money in a savings account, the more time it has to accrue interest.
Set and forget: For those that want an easier saving strategy, depositing funds in an account with a high rate makes compound interest a useful tool. This allows you to make a one-time contribution and leave the account to grow on its own. The higher the rate on your account, the quicker the potential growth. Additionally, your balance may grow quicker if you continue making deposits.
Protect spending power: Compound interest may help protect against the effects of inflation. Putting your money to work in a high-yield savings account, even if the rate doesn’t match inflation, is a better bet than having it in a no-interest checking account… or under your mattress!
While there are many benefits to compound interest, it’s important to remember that returns earned from compound interest may increase your tax burden—you may be responsible for paying income tax on interest accrued over $10.8 Check with your tax advisor for more details.
And, of course, talking about compound interest for your debt is a whole other story. Be sure to understand how interest is applied on any loans or lines of credit you take out because the exponential growth when you owe money is not nearly as fun.
How to Take Advantage of Compound Interest
Now that you understand how compound interest works, here are a few tips that may help you make the most of it as you build your wealth.
Start saving early: Compound interest has some short-term benefits, but you usually see the biggest increase if you leave the money in the account for longer periods of time. The sooner you start saving, the higher your returns may be in the long run.
Choose a competitive rate: When choosing a savings account, look for a high-yield account with competitive rates that may help your balance grow faster.
Continue adding to the account: The higher your account’s balance, the more you could earn in compound interest. When possible, continue adding to your savings account.
Don’t take money out: Your account only earns interest on the money you keep in it. If you make withdrawals, you’re decreasing the amount of interest the account could earn.
Watch for rate changes: Most savings account rates change based on market conditions. Regularly check your account’s rate and search for a better one if your current one isn’t helping you reach your goals.
Whether you have a savings account already or are planning to open one soon, these tips may help speed up your savings.
Accounts to Consider
Ready to grow your wealth? Some accounts that use compound interest and may help you reach your financial goals are:
High-yield savings accounts
Certificates of deposit (CDs)
Money market accounts
While any of these accounts may help grow your money, a savings account is often a great starting point. Even if you don’t think you need a savings account, opening one is an easy way to put your savings to work.
Since each account works differently, it’s best to speak with a financial advisor to help you choose the right accounts for your goals.
The long-term impact of compound interest on savings and investment accounts is powerful because it helps your wealth grow faster. Additionally, it may help protect your spending power as costs rise due to inflation.
To maximize the impact of compound interest on your savings, monitor the rates your account earns and consistently contribute to it.
Want to put your money to work but aren’t sure where to start? Learn how to choose a savings account that fits your needs and may increase your wealth over time.