Interest
Compound Interest
Compound interest summary:
Compound interest is interest you’re paid on previously earned interest.
Compound interest can help your money grow over time.
Money in a savings account or bonds can benefit from compounding.
Compound Interest Definition and Meaning
Compound interest is interest on previously earned interest. Earned interest is added to your principal deposit so you’re able to earn more interest over time.
Comprehensive Breakdown of Compound Interest
Compound interest is interest that's earned on a principal deposit plus previously earned interest. It's also known as interest on interest.
When you have an account with compounding interest, your deposit earns money after a period of time (in many cases, a month). Once that interest is credited to your account, it stays there and gets added to your balance so that the month after, you're paid interest on your new balance—the initial deposit plus the interest you were previously paid.
The frequency at which interest compounds depends on the terms of your account. Some accounts compound interest daily or weekly, while others compound monthly, quarterly, or once a year.
The more frequently interest compounds at a given interest rate, the higher the annual percentage yield, or APY. And the higher the APY, the more you earn. Here's how compounding affects the APY and earnings for a savings account with a 4% rate compounded annually, quarterly, monthly, and daily:
Rate | Initial deposit | Times compounded per year | Balance after 1 year | APY |
5% | $10,000 | 1 | $10,500.00 | 5.00% |
5% | $10,000 | 2 | $10,506.25 | 5.06% |
5% | $10,000 | 4 | $10,509.45 | 5.09% |
5% | $10,000 | 12 | $10,511.62 | 5.12% |
5% | $10,000 | 360 | $10,512.67 | 5.13% |
Compound interest can apply to money you borrow too, though. And in that case, the more frequently the interest compounds, the more your debt can cost you.
Credit cards commonly compound interest on a daily basis, which means that for each day you carry a balance, the more it can cost you.
RELATED: If you need help to address credit card debt, you’re not alone. Learn more about debt relief here.
Types of Accounts That Pay Compound Interest
Accounts that may allow you to earn compound interest on your money include:
Savings accounts
Certificates of deposit
Savings bonds
Money market accounts
Some checking accounts
Examples of Compound Interest
Imagine you deposit $1,000 into a savings account with a 4% interest rate, and that rate stays the same for a full year. If your bank account compounds interest once a year, then after 12 months, you'll have earned $40 in interest for a total balance of $1,040.
If your bank account compounds interest on a quarterly basis, you'll earn a touch more—$40.60. And if your bank account compounds interest monthly, you'll earn $40.74. With daily compounding, you're looking at $40.81 in interest.
The difference between daily and annual compounding might seem small based on this example. But with a lot more money, the difference could be significant. And also, the longer you keep money in an account that earns compound interest, the more you can earn.
For example, if you put $1,000 into an account that pays 4% interest over a 10-year period, and that interest compounds monthly, you stand to earn $490.83 in interest.
That’s why when looking for a bank account, it’s important to compare not just interest rates, but also the annual percentage yield, which reflects the frequency at which interest is compounded. And on the flip side, when you have debt that compounds interest frequently, like a credit card, the sooner you pay it off, the less it will cost you.
Compound Interest FAQs
Compound interest can be a good thing when you’re the one earning it. It can be a negative thing if you’re accruing compound interest on an outstanding debt, like a credit card balance.
It depends on the investment. An investment is anything that you put money into to hopefully earn more money. Certificates of deposit, or CDs, earn interest. Bonds generally pay interest. Some stocks and funds pay dividends. And many stocks and other investments pay no interest at all. However, you can compound your returns by reinvesting them instead of spending them.
It's smart to dig out of mounting credit card debt because your credit card charges interest that compounds every time you carry over a balance from month to month. You may end up paying much more over time when you carry a balance than if you had paid off that credit card in full punctually or over a shorter period. Additionally, late and insufficient minimum payments on credit cards can dramatically hamper your credit rating and lower your credit score. That can make it more difficult to qualify for future credit.
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