Compounding, earning interest on interest, is a powerful financial tool that's sometimes misunderstood by savers of all ages. Regardless of your rate, the more often interest is paid, the more beneficial the effects of compound interest. A daily interest account, which has 365 compounding periods a year, will generate more money than an account with semi-annual compounding, which has two per year. An exception occurs if the interest rate is much higher on the account that compounds semi-annually.
If you find a big difference in daily versus semi-annual account interest rates, you should work out the potential compound effects for both. If the rates are fairly close, you'll always get more earnings with daily compounding accounts. Over time, extra earnings that might seem small, even a matter of cents, will result in many extra dollars because of more frequent compounding.
Simple Interest vs. Compound Interest
The term "simple interest" sounds pleasant and non-threatening. However, do not consider a savings account that pays simple interest. This form of account earnings does not add your interest earned to your account principal. If you deposit $5,000 in a simple interest account paying 2 percent, at the end of a year, you'll earn $100. Every year you'll earn the same $100. After two years, you'll have earned $200. In the first year of a semi-annual compound interest account, you'll earn $100.50. At the end of year two, you'll have earned $203.02. Over time, you'll have much more money on your savings with compound interest accounts.
Time and Compounding
Whether you're considering a daily, monthly or semi-annual compound interest account, an equally important component is time. Over a few years, your account balance won't grow significantly if you don't keep feeding it with deposits. However, over 10, 20 or 30 years, you'll find a major increase in your account balance. For example, according to U.S. News Money, if you start an account with $5,000 at 2 percent interest when you're 25 and deposit $200 per month, you'll have almost $159,000 in your account when you're 65.
The time between postings of interest to accounts is called the compounding period. Compounding periods help people understand the mathematics of the power of compound interest. The compounding period is one day for a daily interest account, and it's six months for semi-annual accounts. Daily accounts earn 1/365 of the interest rate, while semi-annual postings occur twice per year. Although the interest rate is much larger at the semi-annual posting (one-half the annual rate) than at the daily rate (1/365th of the annual rate), the more frequent interest postings over time will earn more interest on interest.
Video of the Day
- Goodshoot/Goodshoot/Getty Images