September, 2021
How Does Compound Interest Work?
You deposit money into the bank, and the bank pays you interest on your deposit.
If you earn 5% annual interest, a deposit of $100 would gain you $5 after a year. The next year, the compounding starts. You’ll earn interest on your initial deposit, and on the interest you just earned.
The interest your money earns the second year will be more than the year before, because your account balance is now $105, not $100.
Example
- Year One: Initial deposit of $100 earns 5% interest, or $5, bringing your balance to $105.
- Year Two: Your $105 earns 5% interest, or $5.25. Your balance is $110.25.
- Year Three: Your balance of $110.25 earns 5% interest, or $5.51. Your balance is $115.76.
With compound interest, even if you don't make any additional deposits, your earnings will increase.
The above is an example of interest compounded yearly. At some banks, interest compounds daily and gets added to your account monthly, so the process moves quicker.
NOTE: If you are borrowing money, compounding works against you and in favor of your lender. You pay interest on the money you’ve borrowed. The following month, if you haven't paid the amount you owe in full, you will owe interest on the amount you borrowed plus the interest you've accrued.
Important Factors in Compounding
Time
The more time you have, the more you can benefit from compound interest. The longer you leave your money untouched, the more it grows, because compound interest grows money exponentially over time.
Frequency
More frequent compounding periods, such as daily, have more dramatic results. Interest payments may be added to your account monthly, but calculations can be done daily.
Annual Percentage Yield (APY)
Look at the APY to compare bank products such as savings accounts and CDs. It figures in compounding and provides a true annual rate. The APY is higher than the interest rate.
Interest Rate
Higher rates mean an account will grow faster, but compound interest can overcome a lower rate. An account compounding at a lower rate can end up with a higher balance than an account using a simple calculation.
Deposits
Withdrawals and deposits affect your account balance. Withdrawing money instead of leaving it or adding to it will lessen the effect of compounding.
Remember
- With compound interest, you earn interest on interest
- At some banks, interest compounds daily, allowing you to grow your money faster.
- Save early and contribute to your account to maximize the benefit of compound interest
- Look at the APY to find the best product
If you have questions about this article or to discuss your financial situation, please contact us.