Depositing money to a savings account can help you prepare for rainy days. You could also grow your money if you’re earning compound interest on your balance. One thing to consider when comparing savings accounts is how frequently interest compounds. Whether you earn interest compounded daily or monthly can make a difference in how much your balance increases over time.
You can work with a financial advisor to understand which type of interest and savings account works best for your situation.
What Is Compound Interest?
Compound interest means the interest on your interest. It’s the interest earned on both the principal amount you deposit and the interest that accumulates on the principal during the time period in which you’re saving.
Simple interest, by comparison, is interest that’s earned on the principal only. For instance, if you deposit $10,000 into a savings account earning 2%, you’d generate $200 in interest over the course of a year. As long as the principal and interest rate remain the same, you’d continue earning the same amount of interest each year.
Earning interest that compounds is usually preferable for savers and investors, as you can get more mileage for your money. Your deposits can grow at a faster rate when you’re earning interest on both the principal and the previously earned interest, versus just getting simple interest.
It’s common to find banks offering savings accounts and other deposit accounts that earn compound interest. However, not all banks are the same when it comes to how often interest compounds.
How Savings Account Interest Works
Traditional banks, credit unions and online banks can offer interest-bearing savings accounts. The amount of interest you can earn depends on:
How much you’re saving
Savings interest rate and APY
Compounding frequency
How long you’re saving
When you open a savings account, you’ll typically need to make an initial deposit. That deposit might be as little as $1 or as high as $1,000, depending on the bank. The money you put into your savings account is the principal.
Savings accounts have an interest rate and an annual percentage yield. The APY reflects the rate of return you can expect on a savings account over the course of a year when compound interest is factored in. The higher the APY, the more interest you can earn.
Banks can compound interest daily or monthly for savings accounts. It’s even possible that interest might compound quarterly or annually. Keep in mind that the compounding frequency may be different from how often interest is credited to your account. Your bank might compound interest daily, for example, and credit it to your balance monthly.
Examples of Savings Account Interest Compounded Daily vs. Monthly
Does it make a difference if interest is compounded daily or monthly? The short answer is yes, it can. How much of a difference it makes can depend on the APY you’re earning and how long you plan to save. Using a savings calculator can help you estimate the future value of your money.Here are some examples to illustrate how interest compounded daily vs. monthly can affect your savings.
Example #1: Compounding Monthly
Assume you deposit $10,000 into a high-yield savings account that offers a 2% APY. You plan to deposit $100 a month into your account for the next 60 months.
After five years, you’d have $17,355.52 in savings. Your total contributions would equal $16,000, with the remaining $1,355.52 representing the interest earned.
Example #2: Compounding Daily
Let’s use the same example again, only this time we’ll calculate interest earned based on daily compounding.
If you were to deposit $10,000 into a high-yield savings account at 2% and add $100 a month to it for five years, you’d still contribute $16,000. But you’d end up with $17,361.75 instead. That’s a difference of $6.23 in interest.
Example #3: Compounding Daily for 30 Years
Earning an extra $6.23 in interest with daily compounding might not seem like much. But that interest could add up to a sizable amount the longer that you save.
Using the same numbers again, let’s assume that you’re saving over a period of 30 years. If you earn the same 2% and deposit $100 a month consistently, you’d have $$67,546.22 to show for your efforts.
Of that amount, $46,000 would be your original contributions. The other $21,542.22 is the interest earned through daily compounding.
The lesson? Daily compounding can give you a slight edge over monthly compounding. But more importantly, the longer you save and the more consistently that you do so, the more money you can accumulate.
How to Make the Most of Compound Interest
If you’re interested in using compounding interest to your advantage, opening a high-yield savings account that compounds daily can be a good place to start. Online banks can offer savings accounts with competitive rates that easily beat traditional banks. You may also pay less in fees for an online savings account compared to a traditional savings account.
A savings account can be a terrific way to earn interest on the money you’re setting aside for emergencies or short-term financial goals. However, you can get an even greater benefit from investing some of your money in the market.
For example, say that you put $10,000 into a mutual fund that earns a 7% annual rate of return. You continue investing $100 a month into that fund for 30 years. Assuming your average rate of return remains the same, your investment would be worth $153,666. Of that amount, $57,609 is compound interest.
Investing in the market does entail taking more risks than you would with a savings account. But as the numbers show, it can be a powerful way to add to your wealth.A professional advisor can look at your financial situation, goals and risk tolerance to help you to develop a strategy for saving and investing.
The Bottom Line
Earning interest compounded daily versus monthly can give you more bang for your savings buck, so to speak. Though the difference between daily and monthly compounding may be negligible, choosing daily compounding can still put a little more money in your pocket. What’s most important to keep in mind is the power of compounding interest itself. If you’re not taking advantage of this tool, you may be leaving money on the table.
Checking Account Tips
Consider talking to your financial advisor about how much to keep in savings and the best places to save in order to maximize compound interest. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’sfree tool matchesyou with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
A high-yield savings account is one option for setting aside money to earn compound interest. However, you might also consider opening a money market account or a certificate of deposit account instead. With money market accounts, you can earn interest on balances, but you may have check-writing privileges or debit card access to your savings. CD accounts allow you to set aside money and earn interest for a set time period. Once your CD matures, you can withdraw your principal and the interest earned. Similar to high-yield savings accounts, an online bank may be the best option for opening money market or CD accounts.
Photo credit: ©iStock.com/andresr, ©iStock.com/martin-dm, ©iStock.com/Olelole
The post Interest Compounded Daily vs. Monthly appeared first on SmartAsset Blog.
