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Understanding Compounding Interest -- What It Is and Why it's Important

Compounding interest is a benefit to you as an investor, allowing you to receive a return on your savings, not just on the initial principal you deposited when you opened your account, but also on the interest earned on the principal. Another way compound interest is defined is “interest on interest.” If you have a savings account that pays a return, you can take advantage of compounding interest. You can receive the most benefit from compound interest if you are able to not withdraw from your savings account and just let it sit and earn a return, adding to it if you’re able. The rate of growth will depend on three things:

  • · Your bank balance

  • · Your interest rate

  • · How frequently your bank compounds interest (daily, monthly, etc.).

Many online savings accounts such as Ally, Discover, CIT Bank, and Marcus by Goldman Sachs offer FDIC insured accounts with competitive APYs, no monthly fees, and interest that compounds daily. You can find a compound interest calculator online and calculate how quickly your balance will grow.


Simple Interest vs. Compound Interest


Simple interest is paid only on principal. Interest is compounded when the interest is added to the balance of your account and interest is earned on that higher balance. For smaller bank account balance, the effect of compounding interest will be minimal, just pennies at first. However, saving for the future is a marathon, not a sprint. If you can save money continually over time, as your balance grows, so will the interest you earn.


Supercharging Your Savings


Interest earned is nice, but you can really help your money grow much faster if you add to it yourself. If you have $1,000 in a savings account with 2.2% APY that compounds daily, your account value after 12 months will be roughly $1,022.56. After 10 years (assuming the 2.2% interest rate stays the same), that account value will be $1,249.88. Now, if you have that same savings account but are able to put $100 per month from your paycheck into it, after one year your account value will be $2,235.19. After 10 years, your account value will be $14,684.03 ($13,000 saved by you over 10 years, and $1,684.03 earned in interest). If you were able to double your savings, putting $200 a month from your paycheck into savings, after 10 years your account value would be $28,118.17 ($25,000 saved by you over 10 years, and $3,118.17 earned in interest).


CD Accounts vs. Online Savings


Certificate of Deposit (CD) accounts are a great option if you don’t need access to your funds. Banks and credit unions offer CD/certificate accounts in many term lengths, from 30 days to up to 10 years. CD accounts often offer higher interest rates than liquid savings accounts, a guaranteed interest rate during the term of the account, and no fees if you hold your account to maturity. Typically, the longer the term of a CD account, the higher the interest will be. With a traditional savings account, the bank may adjust the account at any time, so it is impossible to for sure know how much interest you will earn over the course of a time period. For example, a 5-year CD opened with $1,000 with a 3.10% APY will accrue $0.09 each day in interest. Interest will be credited to the account annually at the end of the year. Total projected interest earned at the end of the 5-year period would be $165.10.


Online banks such as Ally offer CD accounts with no minimum, allowing you to put your money to work for you with even the smallest investment. If you receive a $50 check from a relative for your birthday, you can make that small gift an asset by depositing it and opening up a CD account and letting it grow over time. If you do need to access funds before the maturity day, you will pay a modest penalty. You can also open an IRA as a CD Account and take advantage of compound interest as part of your retirement portfolio.


CD Laddering and Compound Interest


You can create your own CD “ladder” strategy by setting up multiple CDs that mature at different intervals. This spreads out maturities over different dates so you have access to funds if you need it, while taking advantage of longer term rates. For example, if you have children going to college in 1, 3, and 5 years, you may set up CD Accounts that mature in these time periods so you will have access to funds when you need them. The longer term accounts will have the most benefit because they will accrue the most interest.


Planning for the Future


While people take different approaches to investing and planning for retirement, particularly in regards to risk, a savings account should be part of everyone’s financial portfolio. Even if you do not want to go the conservative route of locking most of your money up in CDs and savings accounts, you should have money in an emergency fund. Depending on your goals for the future and how soon you’ll need to access your money in the future, you can use a savings account and earn compound interest on your savings.


All information and materials in this article are for educational purposes only. Opinions expressed in this article are based on information considered reliable, but The Daily Money Show cannot guarantee the accuracy of the information nor should it be relied upon. The information discussed in this article should not be used as a recommendation to buy or sell securities nor should it be taken as investment advice. The Daily Money Show is not a Registered Investment Advisor or Broker Dealer. The Daily Money Show is not an accounting firm and does not give tax advice regarding any security or real estate transaction. You may want to consult with an accountant, attorney, real estate agent or financial advisor before proceeding with any transaction regarding securities or real estate.

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