You may have heard the phrase, "Let your money work for you," and have asked yourself what that means. The simple answer is investing your money that brings returns. Compound interest has the same concept but operates differently than investing and returns only. Compound interest is the foundation for building your savings and is a guideline for building wealth over time.
What Is Compound Interest?
Compound interest is the interest you earn on interest. If you have a savings account or a CD earning compound interest, you will earn interest on the initial principal amount deposited plus the interest accumulating over time.
Compound interest helps increase the growth of your savings and investments faster than simple interest accounts. For example, if you deposited $1,000 in an account that pays 5 percent annual interest, you will have earned $50 after a year ($1,000 x 5% = $50). In year 2, your beginning account balance is $1,050. Now you will earn another 5 percent annual interest on $1,050, which at the end of year 2, your sum will be $1,102.50 ($1,050 x 5% = $1,102.50). Your interest payment will increase as your account balance grows over the years. The combination of compound interest and monthly deposits in your account will accelerate your savings significantly.
Different Compound Interest Payments And Frequency Sets.
Annual interest payments are not the only way a saver can receive interest payments. Many saving accounts, CDs, money market accounts, and other investment vehicles have different set schedules. The bank determines set schedules. Set schedules payments are as follows: daily, monthly, quarterly, semi-annually, and annually.
Set schedule payments differ from compounding interest frequency sets: Compound interest sets are how the interest is compounded. The interest compounded can be done daily, monthly, or annually. This depends on the bank. For example, a money market account may pay interest payments monthly but compound interest daily. So, each day, the bank will calculate your interest for the account plus the interest that has not been paid out yet, but you've earned.
How To Get The Most Out of Compound Interest.
1. Start And Save Early
Regarding savings, investments, etc., the longer you have your money in these accounts, the more interest can accrue. The power of compound interest comes from how long you can receive interest payments. The primary key is time. Look at the example below.
Saver 1: Start saving $200 a month at age 25, earning an average of 5% annually, and the interest compounded monthly for 40 years. Saver 1 will earn roughly $305,204 by age 65 with a principal investment (monthly deposits) of only $96,000.
Saver 2: Start saving $1,000 monthly at age 50, with an initial investment of $5,000, earning an average of 5% annually, and the interest compounded monthly for 15 years. Saver 2 will earn roughly $277,858 by age 65 with a principal investment (monthly deposits) of $180,000.
Even though Saver 2 has invested more of a principal (monthly deposits) into the account of $180,000, Saver 1 will have more funds at retirement due to the length of time that compound interest Saver 1 received on their principal invested (monthly deposits).
https://www.moneygeek.com/compound-interest-calculator/ can help you calculate your interest earned based on rates, time, and amount invested.
2. APY Rates.
The APY is not the same as the interest rate. The annual percentage yield (APY) number will give you a good look at which account or investment product pays more interest. The higher an account's interest rate, the more interest you will earn on your initial investment or deposits. The interest rate only accounts for the interest earned on the original amount. The APY includes interest earned on the original balance but also the amount of compound interest earned in one year. The APY is a better measure to follow.
3. Selecting The Frequency Set of Compounding.
Daily compounding and monthly compounding have been shown to benefit savers best. The more frequent compound sets, the higher the compound payments interest payments. When comparing accounts with the same interest rate, looking at the frequency of compounding interest is a good start.
4. Selecting The Common Saving Instruments.
Banks, credit unions, and brokerage firms offer saving instruments with different rates and compound interest frequency sets. Below are a few examples:
Banks & Credit Union Money Market Accounts / Savings Account: With banks, the standard practice is daily compounding for their savings accounts.
Bonds: Bonds interest is compounded on a semi-annual basis.
Banks, Credit Unions / Brokerage CDs: Interest can be compounded daily or monthly.
The Takeaway
Compound interest is the foundation for building your savings and is a guideline for building wealth over time. It is a powerful tool because it can grow your money faster than simple interest accounts. The main power of compound interest is the combination of the length of time and the rate at which you can receive interest payments. Remember, the higher the number of compound frequencies, the greater the compound interest received.
The information herein is intended for educational purposes only and is not exhaustive. Diversification or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.
FINRA has not reviewed this content.
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