How to Build Your Savings with the Magic of Compound Interest
Reading time: 3 Minutes
September 8th, 2020
Did you know that you can make money just by saving money? It's true: Many savings accounts will pay you interest on the balance in your account, compounding it regularly and increasing that balance.
Compound interest isn't magic, but it can seem like the next best thing. It can help you speed up the rate at which you save, letting you achieve your goals faster, whether it's paying for an awesome vacation, getting a down payment to buy a home or building a nest egg for your retirement years.
What is interest?
Interest is a small percentage of a loan amount that borrowers pay lenders.
When you borrow money from your bank, you pay interest. When you deposit money into certain bank accounts, you earn interest. In effect, you're lending your money to the bank, which can use it to make loans to other people.
How much interest you'll earn depends on the percentage rate being offered by the banking institution, how often the interest is paid and whether you leave the interest in your account or withdraw it.
If you withdraw the interest, you'll earn interest only on the money you deposited. This is known as "simple" interest. "Compound" interest happens when you leave the interest in your account and you begin to earn interest both on the money you deposited and the accumulated earned interest. When this happens, you're getting interest on interest.
To compound interest means to calculate the current level of interest in an account and add it to the principal balance. This can happen daily (every day), monthly (once per month) or annually (once per year). The more frequently interest compounds, the more you'll earn, assuming the rate remains the same or increases.
The rate of return, or yield, is an annualized rate that can help you compare accounts with different rates and compounding frequencies. When interest is compounded more often, the rate of return will be slightly higher for the same rate.
Bank accounts that earn interest
If you'd like to start earning interest, there are several types of bank accounts you'll want to consider.
- Premium checking. Checking accounts that charge a small monthly fee and have a modest opening balance requirement are often interest-bearing. The monthly fee typically may be waived if you maintain a higher combined balance in all of your accounts with the bank.
- Most savings accounts earn interest. This type of account can help you save for short-term needs such as car repairs or vacation expenses, or long-term needs like college costs or a down payment to buy a home. This type of account is also a good choice for emergency savings. You may be able to earn bonus interest rates by depositing on a regular basis and not withdrawing money.
- If you have $2,500 or more that you won't need for at least six months, think about getting a certificate of deposit, or CD, from your bank. CDs can pay slightly higher rates than checking or savings accounts, but you won't be able to withdraw your money from the CD during its term without being charged a fee. Generally speaking, the longer the term of the CD, the higher interest rate you can earn.
Though there are some limits, these types of accounts are usually protected by the Federal Deposit Insurance Corporation (FDIC).
How compound interest can pay off
The great thing about compound interest is that, the longer you save, the more you'll earn, assuming the rate remains stable or increases.
For example, say you invest $10,000 in an account that compounds annually at 1 percent, and deposit $100 every month. After 30 years, you'd have a balance of more than $55,000—and about $9,000 of that will be from compounded interest!
Keep in mind that interest is generally considered taxable income, so you may owe federal and Hawaii state income tax for interest you earn.
You can use a mathematical formula to calculate potential compound interest for your specific situation. An easier option is to use an online compound interest calculator. The calculator does the math for you and lets you test different scenarios to see how much interest you could earn.
Current bank rates
To find out the current rates for different types of interest-bearing accounts, look for a rate sheet on your bank's website or mobile app.
The sooner you open and fund your new account, the sooner you can get compound interest to start working for you.
- Compound interest lets you earn interest not only on principal, but on the interest you've already earned. This can help you save more, faster.
- Interest may be compounded daily, monthly or annually. The more often your bank interest is compounded, the more you'll earn.
To earn compound interest, all you have to do is open a bank account or certificate of deposit (with terms that offer compound interest), and wait.
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