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How Compound Interest Works

written by: P Reddy•edited by: Jean Scheid•updated: 9/26/2013

How does compound interest work? How is interest calculated for your savings account? Find the answers here.

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    Making Your Money Work for You: How Interest Compounds for a Savings Account

    USCurrency Federal Reserve 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.

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    Get the Most from a Savings Account

    Knowing how is interest compounded for a savings account makes it easy to get the most value from a savings account. If a bank is willing to pay interest on the interest they’ve already paid, then it makes sense to invest as much as possible and make as much back as possible. Savvy consumers should make regular deposits into a savings account and not take money out on a whim. Leaving money to grow is the easiest way to benefit from compounding interest. While regular contributions are important, another easy way to save more is to put any extra or unexpected money into savings as well—this includes tax returns, Christmas or birthday gifts, or work bonuses.

    One of the most important ideas to take from this is the damage procrastination can do to a savings account. Putting off saving until next month, next year, or some undetermined point in the future means that money is being left on the table for the bank to keep collecting. While saving does often mean making sacrifices, those sacrifices pay off down the road when all that compound interest can fund a college degree, a new house, or retirement.

    However, few savings account offer as much as a 3% interest rate. To really realize the full benefits of compound interest you may have to invest your money in the stock market. Compound interest is one of the best ways a bank can make their clients’ money work for them. Consumers should use it to their advantage and build their wealth with compound interest.



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