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If you have a savings account, you’re likely familiar with interest — that’s the money you earn by keeping your money in the bank, expressed as a percentage. What you may not realize is that there are actually two kinds of interest: simple and compound.Simple interest is calculated based only on your deposits (called the principal balance of your account). Compound interest, on the other hand, is calculated based on the principal balance and the accumulated interest from the previous periods. This means that compound interest will help your savings grow at a faster rate than simple interest.Read on for a closer look at compound interest, including how it works, its pros and cons, and which accounts earn compound vs simple interest.
What Is Compound Interest?
Defined simply, compound interest is interest you earn on interest. With a savings account that earns compound interest, you earn interest on the initial principal plus on the interest that gets added to the account over time.Many savings accounts and money market accounts, as well as investments, pay compound interest. Recommended: Savings Account vs Brokerage Account
How Does Compound Interest Work?
When a bank offers a savings account with compound interest, they typically apply interest multiple times throughout the year, ranging anywhere from daily to monthly to quarterly and beyond. Every time this interest is calculated, it includes the total account balance of the principal and any previously accumulated interest. So if you open an account with $1,000 and the compounding period is every quarter, the first quarter you’ll earn interest on the initial balance of $1,000. In the second quarter, you’ll earn interest on the balance plus previous interest, and so on. The more frequently interest compounds, the faster your savings will grow.Recommended: What Is the Average Interest on a Savings Account?
Types of Compound Interest
When comparing savings accounts, compounding frequency is as important a consideration as interest rates. The more often an account compounds, the more rapidly this interest accumulates and the faster your money grows. Two accounts with the same interest rate but different compounding frequencies will not grow in the same way.While a bank can choose to calculate and pay interest at any interval it wants, there are generally only a few methods of compounding interest that are actually used:
Annual compounding: Interest is calculated and paid once a year.
Quarterly compounding: Interest is calculated and paid once every three months.
Monthly compounding: Interest is calculated and paid each month.
Daily compounding: Interest is calculated and paid every day.
In some cases, the schedule for compounding interest and paying out the interest may differ. For example, a savings account may pay interest monthly, but compound it daily. Each day, the bank will calculate your interest earnings based on the account balance, plus the interest that you’ve earned that it has not yet paid out. In other words, just because your bank adds interest once a month doesn't necessarily mean that they are compounding monthly.
Types of Accounts That Typically Use Compound Interest
So what is a compound interest account? Basically, any account that earns interest may use compound interest. This usually won’t be a checking account, but will include a traditional savings account, as well as high-yield savings accounts.Money market accounts and certificates of deposit (CDs) may also use compound interest. Compound interest is also often used for loans. In this case, the borrower is paying compound interest and the lender is earning the compound interest.
Compound vs. Simple Interest
Simple interest is the interest paid on the balance of an account. It doesn’t pay interest on the interest added to the account. If you earn 2% simple interest on a balance of $1,000, you’ll earn $20 in simple interest in one year.Compound interest, on the other hand, is calculated based on both the principal balance and previously accrued interest. Naturally, you’d prefer to earn compound interest because your interest helps you earn even more interest on your account. Also, the more often interest is compounded, the better.So how can you tell which type of savings account pays the most interest? Fortunately, it’s easy. The annual percentage yield (APY) on a savings account is a calculation that considers interest rates alongside compounding frequency. APY tells you the real rate of returns you can expect over a year and can be a useful tool for comparing accounts at different institutions with different compounding frequencies.
How Often Is Interest Compounded?
It depends on the financial institution. While banks typically pay interest monthly on savings accounts, the compounding frequency can vary. Many banks compound interest daily, but some will compound monthly. The best way to find out how often your savings interest is compounded is to check with your bank.
Calculating Compound Interest
To calculate compound interest over a certain period of time, there is a (somewhat complex) mathematical formula you can use:A = P(1 + r/n)ntA = Amount of interestP = Principal (your account balance)R = RateN = Compounding periodT = Time periodIf complex math formulas aren’t your thing, not to worry — you can use one of the many free online compound interest calculators.
Example of Compound Interest
As mentioned above, the more frequent the compounding, the more interest you will earn over time. Now, let’s see how this plays out in a compound interest example.Let’s say you put $20,000 each in two different savings accounts. Both accounts pay 3.00% interest, but one compounds interest annually, while the other compounds the interest daily. You wait one year and withdraw your money from both accounts.The balance on the account that compounds annually will be $20,600 after one year.The balance on the account that compounds daily will be $20,609.07.The difference in total interest for one year may not seem like a lot — just $9.07. Over time, however, you begin to see a much larger differential. Here’s a look at the balance for each account after 20 years, assuming you didn’t add any more money to either account during that time:The balance on the account that compounds annually will be $36,122.22, The balance on the account that compounds daily will be $36,441.48. Here the difference between compound frequency is more noticeable — $319.26.
Advantages and Disadvantages of Compound Interest
Pros of Compound Interest
Cons of Compound Interest
You earn interest on your interest
Doesn’t offer immediate benefits for savers
A more frequent compounding period helps your money grow faster
A less frequent compounding period leads to slower growth
Creates a snowball effect that helps you build more wealth over time
Costs you more money with a loan
Compounding interest clearly has numerous advantages for savers. It accelerates your interest earnings, which helps your savings grow faster. You may not see a big difference between simple and compound interest right away. Over time, however, you’ll earn interest on ever-larger account balances that have grown with the help of interest earned in prior years. Over the long term, compound interest can cause your interest earnings to snowball and help you build wealth.Compounding is not such a positive, on the other hand, if you're a borrower. For loans that have a very high interest rate, such as some credit card debt, compounding interest can make it difficult to ever get ahead of your debt. For example, if you have a credit card balance of $20,000 and a 20% interest rate that compounds monthly, you would end up with over $4,000 in interest in one year.
The Takeaway
So what is compound interest? Simply put, it’s interest on your interest. Banks compound savings accounts with different frequency, such as daily, month, quarterly, or annually. The higher your interest rate, and the more frequently your interest is compounded, the faster your money will grow.If you are looking for the best return on your savings, you’ll want to compare savings accounts by looking at APY, which factors in compound interest. With Lantern by SoFi’s online banking marketplace, it’s easy to compare high-yield savings accounts based on APY, as well as fees and balance minimums.Lantern can help you compare online savings accounts and find today’s best rate.
Frequently Asked Questions
What is compound interest?
What is the difference between compound interest and simple interest?
What are the types of compound interest?
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About the Author
Susan Guillory
Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
