Interest on a savings account is the quantity of money a bank or financial institution pays a depositor for retaining their money with the bank. Compound interest is interest calculated on principal and earned interest from previous periods, meaning that your earnings are reinvested and future interest is earned on the higher quantity.
In a manner, a bank borrows money from their depositors by using the deposited funds to lend money to other clients. In turn, the bank pays the depositor interest for their savings account balance while simultaneously charging their loan customers a larger interest rate than what was paid to their depositors.
If you reinvest the interest you earned on your savings account and the initial quantity deposited, you'll earn even more money in the long term. This process of earning interest on your savings plus earning interest on all of the accumulated interest from previous periods is called compounding. Investors can use the concept of compounding interest to build up their savings and create wealth.
Interest on savings accounts is indicated in percentage terms. For example, let's suppose you have $1,000 in the bank; the account might earn 1% interest. Unfortunately, most banks pay less than 1% interest on savings accounts due to historically low-interest rates.
Interest on Interest
In performing an uncomplicated interest calculation, $1,000 that earned 1% interest in one year would yield $1,010 (or .01 x 1,000) at the end of the year. However, that calculation is based on straightforward interest, paid only on the principal or the deposited funds.
Some investors, such as retirees, might withdraw the earned interest or transfer it to another account. The interest installments function as a form of income. If the interest is withdrawn, the depositor's account will earn straightforward interest since no interest would be earned on any previous interest.
However, with interest rates being so low, many depositors may elect to leave the interest earned in their savings accounts. As a consequence, the money in the savings account would earn compound interest, where the interest is calculated based on the principal and all of the accumulated interest.
The Power of Compounding Interest
In savings accounts, interest can be compounded, either daily, monthly, or quarterly, and you earn interest on the interest earned up to that point. The more frequently interest is added to your balance, the quicker your savings will grow.
Using our $1,000 example earlier and employing daily compounding every day, the amount that earns interest increases by another 1/365th of 1%. At the end of the year, the deposit has grown to $1,010.05 versus $1,010 via straightforward interest.
Of course, an extra $0.05 doesn't sound like much, but at the end of 10 years, your $1,000 would grow to $1,105.17 with compound interest. The 1% interest rate, compounded daily for 10 years, has added more than 10% to the value of your investment.
Again, the amount earned still might not seem like much, but contemplate what would happen if you could save $100 a month and add it to the original $1,000 deposit. After one year, you would have earned $16.05 in interest, for a balance of $2,216.05. After 10 years, still adding just $100 a month, you would have earned $725.50, for a total of $13,725.50.
Although the amount is not a fortune, it's a reasonably-sized rainy-day fund, which is one of the primary purposes of a savings account. When money managers speak about "liquid assets," they mean any possession that can be converted into currency on demand.
It is, by definition, secure from fluctuations in the stock market and real estate values. In real-people terms, it's an emergency fund that can be used for unanticipated expenses such as medical expenditures or auto repairs.
Read Also: 4 Ways to Make the Most of Your Investments This Year
The Snowball Effect
To truly comprehend the snowballing effect of compound interest, consider this classic test case, conducted by none other than Benjamin Franklin. The physicist, inventor, publisher, and Founding Father was a bit of a showman, so it must have given him a giggle to initiate an experiment that would not yield results until 200 years after his death in 1790.
In his will, Franklin bequeathed roughly the equivalent of $4,500 each to the governments of Boston and Philadelphia. He stipulated that it was to be invested at 5% annual interest for 100 years. Then, three-quarters of it were to be spent on a worthy cause while the remainder was to be reinvested for another 100 years. In 1990, Boston's fund had about $4.5 million while Philadelphia's fund had about $2 million due to the effects of compound interest.
Start Early, Save Often
Franklin's experiment demonstrated that compound interest can develop wealth over time, even when interest rates are at absolute bottom. If you're considering establishing an account, it's fast and simple to discover the current rates banks are offering by visiting online. Some institutions specialize in high-yield savings accounts.
The finest savings accounts include those offered by banks where interest on the account is compounded daily, and no monthly fees are levied. Banks often express their interest rates as annual percentage yield (APY), reflecting the effects of compounding. Note that the APY and annual percentage rate (APR) are not the same, for APR doesn't include compounding.
What's Compound Interest Compared With Simple Interest?
Compound is interest on your interest, or reinvesting accumulated interest from previous periods. Simple interest is paid only on the principal or the deposited funds.
What's the Long-Term Benefit of Compounding?
Investors can use the concept of compounding interest to build up their savings and create wealth. If you reinvest the interest you earned on your savings account and the initial quantity deposited, you'll earn even more money in the long term.
How Often Is Interest Compounded?
Depending on the sort of account or product, interest is typically compounded monthly, quarterly, or annually. Interest can also be compounded weekly or daily.
The Bottom Line
Unlike Benjamin Franklin, most of us have no wish to evaluate what our savings might be worth in 200 years. But we all need to have a little money set aside for an emergency. Compound interest, combined with regular contributions, can add up to a reasonable emergency nest fund.
