Savings accounts are a popular resource for building wealth. These bank accounts are federally insured and accumulate risk-free interest. As a result, you won’t have to worry about losing money due to poor investment or unfavorable economic conditions. While many people use savings accounts for financial safety, consumers can select from several accounts. Some consumers gravitate towards a compound interest savings account that rewards them for stashing their cash.
Financial institutions offer these accounts, but you can typically get better interest rates with fintech companies. Since online banks have no physical branches and lower overhead, they can pass more of their savings to consumers. Regardless of which financial institution you use to store your cash, compound interest savings accounts have several perks over traditional savings accounts.
What is Compound Interest and How Does It Work?
Compound interest is interest that accumulates at set intervals. For example, you can find a compound interest savings account that pays interest daily, weekly, monthly, or at another frequency. The interest you receive will increase your total balance and impact how much you receive at the next interval. Therefore, the more frequently interest compounds, the more you will earn.
Let’s assume you have $1,000 in your savings account at 4% APY. Most people believe they would receive $40 as an interest payment since 4% of $1,000 is $40. However, you can end up with more than $1,040 if interest compounds monthly in your bank account. After the first month, you will receive $3.33 ($40 / 12 = $3.33). This payment will raise your balance to $1,003.33. Instead of receiving 4% APY on $1,000, you now receive that same interest on $1,003.33. The next interest payment will be $3.34, raising your total to $1,006.67. The following month’s payment will be $3.36. You make a few extra cents because of the intervals. If interest compounds daily, you make even more.
In our example, we assumed a 4% interest rate for your savings account. While this may sound too good to be true at traditional financial institutions, you can get a 4.00% APY right now with online banks.
Simple vs. Compound Interest
Simple and compound interest both increase your wealth but at different intervals. Simple interest is an annual calculation. For example, if you have $5,000 in the bank and earn 1% interest, your account balance will be $5,050 at the end of the year.
A compound interest savings account with a 1% interest rate grows differently. If it has weekly intervals, the weekly interest payments will contribute to future interest. You will end up with more than $5,050 at the end of the year because of compounding interest.
You can use a compound interest calculator to see how much you would earn for weekly compounding. For example, $5,000 compounded monthly at 4% APY leaves you with $6,105 after five years. If your funds only get compounded annually at the same rate, you only end up with $6,083. Securing higher interest rates on savings accounts and a higher compounding frequency will increase your total returns.
Compound Interest Example
We will use an example of a 2% APY on a compound interest savings account with $10,000, half of the APY you can get with virtual banks. The bank, in this example, pays in monthly intervals throughout the year. A simple interest savings account will have a $10,100 balance in six months. You can get a higher balance with a compounded interest savings account that has the same APY over six months.
- Month 1: $10,016.67
- Month 2: $10,033.36
- Month 3: $10,050.08
- Month 4: $10,066.83
- Month 5: $10,083.61
- Month 6: $10,100.42
You end up with an extra $0.42 after six months. While this amount of money will not change your life, free proceeds will continue compounding as you build up your savings. More frequent compounding lets you get extra money without extra effort. You can increase your payouts with a higher balance by finding a savings account with a higher compounding interest rate. Reinvesting each interest payment back into the account will also increase the following month’s payment.
How Does Compound Interest Affect Your Savings?
Understanding how compound interest works can help you decide where to put your money. Compound interest allows your savings to grow faster than a traditional savings account. If you put $1,000 into a savings account with annual compounding at a 4% rate, your savings account will grow to $1,480.24 in 10 years. Switching to a compound interest savings account with daily compounding turns $1,000 into $1,491.79 in 10 years.
It’s extra money without any additional work. A compound interest savings account works harder than a simple interest savings account. You work hard to earn money, and the more it works for you, the more opportunities you will have later in life. You can have a smoother retirement by focusing on every optimization and utilizing your money smartly.
The Types of Compound Interest Accounts
Parking your money in the right compound interest account can result in a higher rate for your principal. Having your money work harder for you can speed up your path to your next financial goal and create more possibilities. Each account has pros and cons worth considering.
- Checking Account: This account has the lowest compound interest and is primarily for everyday expenses. You can freely use these funds to cover purchases without worrying about penalties.
- Certificate of Deposit: These accounts have higher interest rates but often require that you lock up your money for a set duration. Most banks let consumers start with a 3-month CD and offer multiyear CDs as well. You shouldn’t access funds until the certificate’s maturity because early withdrawals result in penalties. This funding choice is best for money that you do not need for a while.
- Money Market Account: This investment product lets you access short-term bonds and T-bills. You can get a debit card linked to a money market account and have free access to the cash in your account. It’s a reliable middle ground between the low-interest checking account and a CD’s lockup timeframe. Money market accounts have higher interest rates than checking accounts, but you will find a higher rate with a certificate of deposit.
- High-Yield Savings Account: This account offers a higher rate than the typical savings account. These financial products have various interest rates, minimum deposits, fees, and other requirements. Some accounts let you withdraw a portion of your funds, while others are less generous.
Other Factors That Affect How Much You Earn from Your Savings
The type of savings account you select plays a role in how much interest you earn. Knowing the other factors can maximize your earnings and enable you to hit your financial objectives sooner. These elements impact how much interest you receive at each interval.
The Balance in Your Account
Your account’s balance is a decisive factor that determines how much interest you earn. You have more control over this factor than any other. A consumer can double their interest payment by opening an account with a $2,000 deposit instead of a $1,000 deposit.
Bank account holders can raise their interest payments by contributing more money to their savings accounts each month. You can create a certificate of deposit to collect interest, but these accounts usually have penalties for early withdrawals.
You can increase your monthly contribution by increasing your income or lowering your expenses. Cutting costs is the more straightforward approach when getting started. You can review spending insights from your bank to discover opportunities to eliminate expenses and keep more of your earnings. While cost-cutting provides immediate benefits, you can only lower expenses so much. Growing your income with a higher-paying job, side hustle, and other strategies is the long-term path to a high balance in your savings account.
Your Interest Rate
Banks set interest rates on their savings accounts. These rates determine your rate of return, and most banks prefer to keep their money close. Most savings accounts have an annual interest rate well below 0.5%, and you will find even lower rates with checking accounts. Finding a bank with a rate double your bank’s rate has the same change as doubling your balance in your existing account. A 4% APY on a daily compounding savings account lets you get more mileage out of your money. You can make as much interest with $1,000 at 4% APY as you would with $8,000 at 0.5% APY. Both choices net you $40 at the end of the year.
Account Fees
Account fees don’t affect how much interest you receive, but they will lower your return on investment. High account fees can minimize your profit and make lower-interest-rate accounts with no fees more attractive. If you receive $30 in interest payments and pay a $5 fee to maintain the account, you only end up with $25. Some people may be happy with the arrangement if the yield is respectable. Someone may not mind if their $500 produced a $25 interest payment at the end of the year, but if it takes $10,000 to achieve that same payment, the fee becomes more noticeable.
While any profit is better than no profit, you must consider account fees when calculating your return. Some banks waive fees under certain conditions, such as meeting a minimum deposit requirement, and some financial institutions have higher fees than others. Reviewing several banking options will help you find compound-interest savings accounts with high interest rates and minimal fees.
Maximize Your Compound Interest Savings with a High-yield Savings Account
Compound interest savings allow you to accumulate money without taking any risks. You can make more money with stocks, crypto, and other assets, but you can also lose a lot of money during a downturn. Savings accounts are easily accessible and offer risk-free money. By putting your money into a high-yield savings account amplifies the benefits of a savings account. You make more money without having more funds in your account.
