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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.
This interest method helps your account balance grow over time, even if you don’t add money to the account often or at all. This is good news when it comes to your savings account because it means your money could grow exponentially.
Let’s look at how compound interest works, its benefits, and how you could take advantage of it.
Key Takeaways
Compound interest earns interest on both the principal balance and previously accrued interest.
Compound interest is commonly used with both savings accounts and investment accounts.
The longer you keep money in your account, the more compound interest it may earn, potentially growing your savings faster.
What Is Compound Interest?
Compound interest is the way interest is calculated for many savings accounts and other deposit products. It 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. A quick note: savings products express rates as Annual Percentage Yields (APY) which factor in the benefit of compounding interest.
The longer you leave your money in an account that earns compound interest, the more interest you could earn over time. This is the power of compounding interest—it puts your money to work and helps it grow effectively on autopilot.1
Time makes compounding even more beneficial because each time the calculation compounds, there is an acceleration or an increase in the money you can earn. The more money you have in the account, and the longer you leave it in that account, the more interest it may earn, which could help your savings grow exponentially.
Compound Interest Periods
The rate at which your money grows 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 the interest-on-interest calculation occurs less often.
Here are the most common compounding frequencies for several common savings account types and products:
Account Type | Standard Compounding Schedule |
|---|---|
Daily or monthly2 | |
Daily or monthly3 | |
Daily or monthly4 | |
Semi-annually (every 6 months)5 |
When choosing an account, be mindful of 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, 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 compound interest, but it’s easier to use a compounding interest calculators. These calculators let you play with different factors like the amount of money you’re contributing to the account, how often you’re adding money, and the compounding frequency so you can better understand how your actions and the account you choose influence the rate at which your money grows.
Compounding Interest at Work
To further help you understand how compounding interest works and what it could do for your savings, let’s look at two examples.
Example #1
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 into the account.
In the first month, the account would earn about $83.17 in interest.6 This interest 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.
With this rate, your account would earn about $1,025.35 in interest7 in one year, resulting in a balance of $21,025.35.
Example #2
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. Let’s assume that the account earns a consistent annualized rate of return of 7.0% and you don’t make any withdrawals until you retire at 65.
When you turn 65, the account would have a balance of approximately $2,285,840.8 Had you saved the $10,000 per year in an account without compound interest, you’d have approximately $400,000.
Compound Interest vs. Simple Interest
In addition to compound interest, you may also encounter simple interest when looking at banking products. Simple interest doesn’t consider previously accrued interest in its calculation. Instead, it only considers the principal amount.
This interest accrual method is more common with loans than it is with savings accounts. Here are some examples of financial products where you’ll likely encounter simple interest9:
Car loans
Personal loans
Mortgage loans
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. This could reduce the overall cost of your debt. On the other hand, compound interest works in your favor when building your savings because of the growth potential. No surprise—exponential growth with your savings is fun!
Benefits of Compound Interest in Savings
Now that you 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: Compound interest could help you increase your savings over time. The longer you leave money in your savings account, the more time it has to accrue interest.
Protect your 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!
Grow your funds on autopilot: Compound interest could allow you to make a one-time contribution into an account and leave it to grow on its own. The higher the rate on your account, the quicker the potential growth. Keep in mind that your balance may grow faster if you continue making deposits.
Putting your money to work for you may help reduce stress about your money. In our Mind-Money Connection study, we learned that financial stress leads to a lack of sleep in 52.8% of individuals surveyed and contributed to 30.1% of people experiencing strained relationships with their family and friends.
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 $10.10 Check with your tax advisor for more details.
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 a 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, so try to continue adding to the balance. Setting up automatic transfers could take the stress out of this process.
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:
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 savings account type works differently, it’s best to speak with a financial advisor to help you choose the right accounts for your goals.
Final Thoughts
The long-term impact of compound interest on savings and investment accounts could be powerful because compound interest may help 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 rate your account earns and consistently contribute to the balance.
Looking for a high-yield savings account with competitive rates? Check out Jenius Savings today!