Making Your Money Work for You: How Interest Compounds for a Savings Account
In tough economic times like these, people may be skipping out on contributing to their savings account or emptying their savings account just to get by. When they take a look at how much money they can make with the power of compound interest, emptying the savings or stopping contributions might not seem like such a good idea.
When a savings account is opened, an initial deposit is made. A good example to start with is $1000. To look at a 3% interest rate—again, just as an example—one might think that 3% interest means that $1000 will earn 3% of that amount in a year. However, that’s actually the simple interest calculation, which is not what banks use.
Compound interest looks at your balance daily and compounds the interest based on that amount. So with the $1000 example, after one day the compounded balance would be $1000.08, meaning that the $1000 earned $0.08 in interest. Compounding interest means that next time interest is compounded (the next day, in most banks), interest will be paid both on the initial deposit and on any interest previously earned. While interest is compounded on a daily basis, it is typically paid on a monthly basis.
After one year in the previous example, instead of having $1030, the balance would be $1030.45. While a $0.45 difference may not seem like much, compound interest would make a much larger impression for people who make regular contributions to their savings accounts or leave money in savings for longer than a year.