What is compound interest?
Quick insights
- Compound interest is the interest your account earns on interest over time.
- How frequently your interest compounds and how long you let interest compound affects how much interest you earn.
- High yield savings accounts (HYSAs), certificates of deposit (CDs) and money market accounts (MMAs) are common types of savings accounts that tend to compound interest.
Using a savings account can encourage you to work toward financial goals. However, there are certain types of savings accounts that also allow you to grow your savings over time. Parking money into a savings account may be appealing because you have access to those funds, but they also can earn interest until you need to use them.
There are different ways for accounts to earn interest. Simple interest earns money on the amount you deposit, but compounding interest earns interest on your interest.
In this article, we’ll discuss what compound interest is and how it works.
Interest explained
To understand compounding interest, first let’s discuss what interest is.
Interest is the money you earn from keeping funds in a savings account or other interest-bearing account. The rate your account earns interest is the Annual Percentage Yield (APY), and that rate varies depending on the bank and the type of account.
In addition to the rate, the way interest is calculated affects how much your account can earn. Generally, there are two types of interest—simple and compound:
- Simple interest is based on the principal – the original amount you deposit into a savings or interest-bearing account.
- Compound interest is based on the principal balance as well as interest you earn on that balance over time.
With the ability to earn interest on your deposit as well as interest, compounding interest tends to provide a higher rate of return than simple interest, which only grows based on the principal deposit.
How does compounding interest work?
Compound interest factors in the principal deposit as well as any new deposits, which includes interest earned on the account.
For example, let’s say you deposit $500 into a savings account with an annual interest rate of 5%, compounded annually. In the first year, your interest earned would be 5% of $500, which is $25. This interest is then added to the principal, making the total amount $525. In the second year, interest is calculated on the new total of $525, resulting in an interest payment of $26.25, and a new total of $551.25.
Each year, the amount you earn from interest grows a little because it's calculated on a bigger amount than just your original $500. This is how compound interest helps your money grow over time.
How compounding interest helps grow savings
Time is often compounding interest’s best asset. Letting your interest compound is one way that your money can grow your savings, even if you never contribute anything beyond your initial deposit.
How much interest you earn in a compound interest account will depend on a few factors including:
- How much you initially deposit
- How much money you add to the account (additional deposits)
- The interest rate (APY)
- How often the interest compounds
Interest compounds at different rates, and typically, more frequently compounding interest results in more earned interest. Accounts can compound daily, monthly, quarterly or annually. Most savings accounts tend to compound interest monthly.
To determine how much a savings account can earn, you may want to calculate the interest on your savings. This may help you see how the compounding frequency affects how much interest you earn.
What to look for when considering compound interest accounts
Many savings accounts compound, but some compound interest accounts may align with your goals and priorities more than others. Be it a certificate of deposit (CD) account, money market account or high-yielding savings account, there are a few attributes of these accounts that may be worth considering when deciding where to keep your savings:
- Interest rate: Higher interest rates are generally desirable because they tend to have larger impacts on the rate your money grows.
- Compounding frequency: The more frequently interest is compounded, the more earnings you may accumulate over time.
- Fees: Fees have the potential to eat into your interest earnings, especially if they are high relative to the interest you are earning.
- Minimum balance requirements: Some accounts require a minimum balance to open or maintain the account without incurring fees. You may want to evaluate if you are able to meet these requirements without stretching your financial resources.
In summary
Compound interest provides a way to help your savings grow over time. Unlike simple interest which only factors in the initial deposit, compounded interest is applied to your principal deposit and any interest earned on the account. Because compounding interest is continually working with the growth of your account—not just the initial deposit—the account balance may steadily grow over time.
Interest can compound on a daily, monthly, quarterly or annual basis. In general the more frequently interest is compounded, the more your savings grows. HYSAs, CDs and MMAs are all savings accounts that tend to use compound interest.
