Compound interest is a favorable method of compensating lenders and depositors in which interest is periodically credited to the principal and subsequent interest is paid on the growing balance. In other words, compound interest simply earns interest on interest.
Interest is how people who lend money and those who keep money on deposit get paid. This is how bank customers make money.
Investors making loans to public companies by buying bonds or other debt securities that mature or mature at some point in the future. At maturity, the investor’s initial investment, called the principal, is repaid plus interest, which is credited at a specified percentage rate. Depositors are savers who deposit money into various types of accounts at banks, brokerage companies or other depository institutions and earn interest on their funds as long as they remain in the account.
Interest can be earned in different ways. Simple interest is paid only on the basis of the initial investment or principal deposit. Compound interest works differently. With compound interest, interest payments are added to the principal at regular intervals and all future interest is paid based on this steadily growing balance.
Capitalization is a powerful and potentially very profitable financial concept.
When an individual or a financial institution such as a bank, Insurance Wall Street company or brokerage makes a loan to a third party, they profit by earning interest. When an investor lends money to the government or a public company by buying a bond, they also earn interest.
Compound interest works by paying stated interest on a predetermined regular schedule and continually adding the interest to the original principal. Each new interest payment is calculated based on the new balance, which of course is always higher than the previous one. By this method, the interest payments always increase and the principal increases faster than it otherwise would with simple interest.
The phenomenon at work is called composition. Compounding refers to the tendency of compound interest instruments to automatically compound their value in a self-sustaining and ever-increasing manner.
For our first example, we are looking at a hypothetical money market account offered by a regional bank which advertises 1% annual interest compounded monthly. Let’s say our depositor, Sally, deposits $10,000 on January 1st.
Here’s what the first four months would look like (rounded to the nearest penny).
|1st of March||$8.34||$10,016.67|
|First of April||$8.35||$10,025.02|
Since Sally has chosen a compound interest account, her bank adds the interest earned to her account on the first of every month. When the next interest calculation occurs, it’s based on a higher balance than the previous month, resulting in a higher interest payment – and a higher balance – each month.
The effects of compounding are even more dramatic with larger investments. Consider an entrepreneur named Mary who sold her business to an international conglomerate for $1 million. On the first of the year, Mary placed her windfall in a five-year certificate of deposit paying 4% which is also compounded monthly.
Mary’s first four months of interest payments and balance increases would look like this (rounded to the nearest penny).
|1st of March||$3,344.44||$1,006,677.77|
|First of April||$3,355.59||$1,010,033.36|
The dollar amounts are higher, but the effect of compound interest is the same: increasing interest payments and increasing balances over time.
Compounding frequency refers to the length of time between interest payments and represents how often an account balance is recalculated. Monthly, semi-annual and annual are popular dialing frequencies.
The rates that institutions pay to depositors are expressed in annual terms. Clients who take advantage of compounding will return an amount slightly above the quoted rate. APY is the broader measure that takes compound interest into account.
Understanding compound interest is understanding a great way to make your money grow. Banks and other financial institutions compete fiercely for consumer deposits. Savers and investors who know the value of compounding and how compound interest works will have a great advantage over those who don’t.
Knowing about compound interest will allow you to properly assess bank accounts, money market accounts, CDs and other financial instruments and choose the one that best suits your needs.
When choices are available, smart savers will choose compound interest over other less profitable alternatives. Knowing the concepts surrounding compound interest can make you a smarter saver and put money in your pocket.
Most types of deposit accounts can and do pay compound interest. Savings accounts and money market accounts are popular savings vehicles that typically offer this valuable feature. Not all checking accounts pay interest, but if they do, they will also offer compound interest. Term deposits such as CDs can also pay compound interest, but read the fine print because not all of them do. Mutual funds that invest in bonds also offer compound interest, but they are not insured by the Federal Deposit Insurance Corporation and pay income in the form of dividends rather than interest.
When it comes to compound interest, the higher the compounding frequency, the better. It might be possible to find money market accounts compounded daily, which would be ideal, but monthly compounding is more popular. If you have a choice, choose daily capitalization rather than monthly, monthly rather than semi-annual and semi-annual rather than annual. The faster the capitalization, the faster you earn.