Albert Einstein famously called compound interest “the eighth wonder of the world.” Understanding compound interest can help your money work for you — not against you. But what exactly is compound interest and how does it work on savings accounts? Keep reading to learn more.
What Is Compound Interest?
When money compounds, the interest is calculated based not just on the principal amount or the initial investment, but on interest earned. In the case of earning interest, such as with savings or investments, this is good. You earn money on the interest you earn.
When you are borrowing money, compound interest is bad. You pay interest not just on what you initially borrowed or charged on a credit card, but also on the interest that accrues monthly if you don’t pay your balance in full.
What Is a Compound Interest Savings Account?
A compound interest savings account is one where you earn interest on not just the initial money you deposited, but also on the interest you earn on a daily, weekly or monthly basis. Here’s an example:
- You invest $100 into a high-yield savings account with 4% interest.
- The interest is compounded monthly.
- You don’t make another deposit into the account.
- In the second month, you will earn interest on $104, instead of just $100.
- The next month, you’ll earn interest on $108.16. This breaks down to your initial deposit plus the $4 interest from the first month and the $4.16 interest you earned the second month.
It’s easy to see how savings can add up quickly when you choose a savings account with compound interest. It is the closest thing you will find to free money. Although you do have to pay taxes on money earned in a savings account.
Compound Interest Formula
Compound interest dates back to the Old Babylonian age. Today, we use the following formula to calculate it:
A = P (1 + r/n) (nt)
- A is the interest accrued.
- P is the principal deposited before interest.
- r is the annual interest rate in decimal form.
- n is the number of times interest is compounded each year.
- t is the number of years the principal remains in the account.
You can also use a compound interest calculator to find out your compound interest over time without doing the math yourself.
Choosing a Savings Account
Some savings accounts only offer simple interest. Simple interest means you only earn money on your balance, not on the interest. So, if you have an account that offers 4% interest monthly and you deposit $100, you’d earn just $4 each month. The only way you could increase your interest earnings would be to make another deposit into your account.
When you choose a savings account, read the fine print carefully to see if interest is compounded daily, weekly, monthly, quarterly, annually — or not at all. If interest rates on two accounts are the same, and all other aspects such as monthly fees are the same, you are better off choosing the one where interest compounds more frequently.
Good To Know
When comparing savings accounts, look at the annual percentage yield rather than the interest rate. The APY factors in compound interest, making it easy for you to choose the savings account with the highest yield.
Understanding what compound interest means is key to growing your money. You should use this knowledge to find a compound interest savings account where your interest compounds daily to help you build wealth faster.
FAQHere are the answers to some of the most frequently asked questions regarding compound interest savings accounts.
- Can you get a compound interest savings account?
- Most banks, neobanks and credit unions offer compound interest savings accounts. Not every bank lists their offering as compound savings, so you may have to read the fine print.
- While it’s typically better to find a compound interest account, an account with a 4% interest rate, compounded annually, is better than a 0.01% account where interest is compounded daily.
- When you are choosing a compound interest savings account, you can compare annual percentage yields to find the best interest rate.
- What bank has a compound interest savings account?
- Discover has one of the best compound interest savings accounts, with an APY of 4.30% and interest compounded daily and paid monthly, with no monthly fees.
- Where can I get 7% interest on my money?
- Most banks do not offer interest rates as high as 7% on checking or savings accounts. Landmark Credit Union advertises 7.50% interest on their checking account, but it is only available on balances up to $500. Customers must agree to receive eStatements and must have direct deposit of at least $250 per month.
- For higher earnings, investors typically look to the stock market. The annualized return of the S&P 500 over the past 30 years is 9.9% when you reinvest dividends.
- How much is $1,000 worth at the end of 2 years if the interest rate of 6% is compounded daily?
- If you put $1,000 into a compound interest savings account offering 6% interest compounded daily, after two years you would have earned $127.49. This would bring your account total to $1,127.49.
- That may not sound like a lot of money, but it represents $127.49 in free money that you didn’t have to work for. You only had to choose the right initial investment. After 20 years, you would have $3,319.79.
Information is accurate as of Sept. 1, 2023.