One of the upsides to keeping your money in a bank account is the chance to earn compound interest — you earn interest on both the funds you deposit in an account and on the interest that money earns.
On the flip side, when you use a credit card, you’re charged interest on the unpaid interest.
While compound interest increases the cost of borrowing, it’s your best friend if you’re trying to build up your savings. Here’s how compound interest works.
Simple interest vs. compound interest
With simple interest, you earn interest only on the money you deposit, not on the interest your money earns.
Let’s say you put $2,000 into an account with a simple interest rate of 2%. At the end of one year, you would earn $40 in interest if you didn’t add or take out any money. That’s because 2% of $2,000 is $40.
Most savings accounts — high-yield savings accounts, money market accounts, and certificates of deposit — earn compound interest, helping your assets grow faster. With compound interest, you earn interest on all the money in your account, including earned interest.
Using those same figures from above, if you added $2,000 to a savings account with an interest rate of 2% that compounds monthly, you would earn $40.37 in interest at the end of one year, or $0.37 more than with simple interest. An extra $0.37 probably doesn’t seem like much, but at the end of five years, you would earn $210.16 in interest, or $10.16 more than from simple interest.
Savings accounts typically compound daily or monthly. That means interest will be calculated and added to the account every day or every month. The more often interest compounds, the more interest you earn.
How to earn more money with compound interest
Certain factors can help you get the most out of compound interest:
Interest rate: The higher the account’s interest rate, the more money you can earn. With most savings accounts, banks advertise annual percentage yield, or APY, to signify how much the account will earn with compounded interest in one year. The APY reflects the interest rate and how often interest compounds. The higher the APY, the better.
Compound frequency: The more regularly the interest compounds — say, daily versus monthly — the faster your money will grow. If you add $2,000 to an account earning 2% interest that compounds daily, you would earn $40.40 in interest in one year. If the account compounds monthly, you would earn $40.37. If you have a large amount of money in an account, it can add up.
Time: Time is your best friend when it comes to compound interest. For example, if you opened an account with $5,000 at a 5% interest rate that compounds monthly, and left it alone for 30 years, your money would grow to $22,338.
You can use a compound interest calculator to see the impact of compound interest over time.
What to look for in a compound interest savings account
There are several types of compound interest accounts. The best option is one with a high APY and low fees. Before you open an account, you should research:
Minimum balance required, if any
How often you can withdraw money from the account
Common types of compound interest accounts include:
Traditional savings accounts: Savings accounts typically offer very little interest, especially those from large brick-and-mortar banks.
High-yield savings accounts: These are savings accounts with much higher interest rates. The best rates on high-yield savings accounts tend to be from credit unions and online banks, and the rates change frequently.
Money market accounts: High-interest earning accounts that often can be used with checks and debit cards. You may need to keep a large amount of cash in the money market account to avoid paying fees. Rates change frequently.
CDs: Certificates of deposit earn fixed, comparatively higher interest in exchange for keeping your money “locked” in the account for a set period of time known as a term. If you take your money out of the account before the term is up, you’ll usually have to pay a penalty. CD terms range from three months to five years, and interest is typically compounded daily or monthly.
How to avoid paying compound interest on credit cards
Interest on credit cards typically compounds daily. You can use credit cards without any interest charges at all by paying the whole balance each month.
Many people do that, but many others pay only part, rolling over the balance. Interest accrued on that balance is added to your principal so that you pay interest on your interest.
If you can’t pay in full, pay as much as possible — at least enough to cover the interest accrued. You may be able to blunt the impact of compounding by making your payment before its due date or by making more frequent payments, say, twice a month.