$0 at the end of 2030
$0 at the end of 2030
$10,614 in 5 years
Avg. Checking Account
Avg. Savings Account
*Based on average savings account rates of 0.09% APY and average interest checking account rates of 0.04% (Value Penguin)
In all his brilliance, Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
The idea of compound interest has many people scratching their heads. You may have heard of it but have no idea how it works. Relax. You’re not alone. Compound interest—expressed as a percentage—is the interest you earn on interest. To illustrate:
Say you have $300 in an account that earns 2% interest each year. At the end of the first year, you’ll have $306 in your account (unless you’ve made additional deposits or withdrawals). At the end of the second year, you’ll earn 2% interest on your initial deposit of $300 and on the $6 you already earned in interest, for a grand total of $312.12.
That may not sound like much, but if you don’t touch your account in 10 years, you’ll have $365.70, thanks to compounding interest.
Compound interest is interest paid on your initial deposit as well as on the interest earned on that deposit. Bank accounts, like savings accounts, investment accounts, and money market accounts, all pay interest. Depending on the account, interest compounds either daily, monthly, quarterly, or yearly. The more often the compounding, the more interest you will earn overtime
The interest you earn on your account can be either simple or compounded.
Simple Interest - Simple interest is calculated on only the principal amount of your deposit or loan. It is a fixed percentage on the principal amount only.
Compound Interest - Compounding interest is calculated on both the principal amount and the interest earned on the principal. Compound interest accrues every period.
Compound interest works best in the long term. That’s because compound interest grows larger over the years. Also, if you add to your account and refrain from withdrawing funds, you’ll earn even more interest. Compounding interest is best on investment and savings accounts. But, if you’re trying to pay off a loan, it can actually work against you because it adds to your payoff balance.
Apart from that, how often your interest compounds also matters. Daily, weekly, or even quarterly compounding has more dramatic results than yearly compounding. So, if you’re opening a savings account, shop around for accounts that compound daily.
But, some accounts only compound interest monthly or quarterly (or annually), so don’t be too surprised if you can’t find daily compounding. Of course, the amount of your initial deposit and the interest rate also play a part in how much you’ll earn over time.
The formula commonly used to calculate compound interest is as follows:
A = P (1 + [ r / n ]) ^ nt
A: the final amount
P: Your principal or initial deposit
r: this is the annual interest rate
n: this represents the number how often interest is compounded per year
t: How long in time (years) your money compounds
Of course, it’s much easier to determine compound interest on your savings account, investment account, or loan by using a compound interest calculator.
An initial deposit is money you deposit into your bank, credit union, or other financial institution to open a savings account. It’s even possible your bank will charge a fee to open the account. You also may be required to deposit a fixed amount or maintain a minimum daily balance to avoid paying fees.
If possible, you want to avoid these fees to maximize your savings. Even a small deduction every month can add up over time.
Monthly savings contributions are deposits you make into your savings account every month to reach your goal(s). You can make as many or as few contributions as you’d like, but the higher your balance, the more interest your money will earn.
If you make periodic withdrawals from your savings, making monthly contributions will save you from paying a fee if your account falls below your fixed minimum balance.
Your savings goal can be whatever you want to save up for. Think of it as the blue ribbon at the end of a race. It can be a home, a new car, or an emergency fund for those unexpected surprises. Setting a savings goal will help you stay on task and ensure you actually put money into your account.
How long you save depends on your goals, the amount of your initial deposit, and how much money you’re able to contribute to your high yield checking account each month. For instance, if you’re saving for retirement, decide at what age you might be able to retire and set a savings goal for that date.
APY stands for Annual Percentage Yield. APY is the real rate of return on your savings, taking into account compounding interest. Unlike simple interest that is paid on your original principal only, compounding interest is calculated periodically–daily, monthly, quarterly or yearly–and allows you to earn interest on your principal and the interest you’ve already earned. Because APY is variable on savings accounts, it can rise or fall based on market conditions.
Most banks and credit unions compound interest daily or monthly. That means you’ll get small amounts added every month (or every day) and interest is calculated based on that new, higher balance. Interest that is compounded daily puts more money in your savings account than interest compounded monthly. But the amount is very small.
For example, if your initial savings deposit is $100,000 with a 3% APY, in one year, you’d earn $3 more if compounded daily instead of compounded monthly.
It would be great to have a genie in a lamp that pops out and grants your wish to get rich quick, but unfortunately, that only happens in fairy tales. And maybe. Compound interest may or may not make you rich.
Compound interest will earn the most interest on a savings and investment account, but with interest rates so low, even after ten years, the interest you earn might be less than $100. Of course, it all depends on your original deposit and if you make regular deposits into the account. Compound interest earns you much more than simple interest, so in that way, yes, it can make you rich.
Savings accounts, CDs, and checking accounts all earn compound interest. Also, 401(k) accounts and investment accounts, mortgages, personal loans, credit cards, and student loans also compound interest.
Banking services provided by Evolve Bank & Trust; Member FDIC.
OnJuno is a financial technology company, not a bank.