– Compounding Interest –
You might see some that advertise compounding interest daily or monthly. Which is better for you? Many banks have also been trying to lure deposits by the way they calculate total interest returns.
Specifically, some banks will compound interest on a daily basis, rather than monthly or quarterly, and this can lead to additional income for the account holder.
How Does Compound Interest Work?
Compound interest can be a powerful tool for helping you achieve your financial goals. The basic idea is that as you earn interest, you are not only earning interest on your original sum of money, but you earn interest on the previous interest payments.
For example, if you start with $100 and earn 1% in interest, you end up with $101. The next time interest is calculated, you will earn 1% of $101, giving you a total of $102.01.
A = The future total value.
P = the initial deposit.
r = the annual interest rate.
n = the number of times that interest is compounded per year.
t = the number of years the money is save.
Over time, compound interest can help generate additional income. So it stands to reason that the more you are able to deposit, the more you’ll earn long-term. Let’s take a look at an example to see how much money you can earn.
Let’s say you have a savings account with an APR of 2%. If interest is compounding daily, that means that there are 365 periods per year and that the periodic interest rate is .00548%.
The APY on the account would be:
- (1 + 2.00/365)365 – 1 = 2.02% APY
This is very slightly higher than an account that compounds your money once every month.
Assuming that the APR is the same, accounts with monthly compounding offer a lower APY than accounts with daily compounding. Returning to our previous example of an account with an APR of 2%, the APY of the account would be:
- (1 + 2.00/12)12 – 1 = 2.01% APY
In reality, it is much less than a difference of 0.01% compared to daily compounding. The minuscule difference in interest will have little effect on how much interest you earn unless you have a very large balance.
What Happens if Balances Change During the Month
If you move money in and out of your savings account, you might wonder how it will affect the interest that you’re paid.
In fact, there’s relatively little difference in how moving money affects the accrual of interest whether interest is compounding daily or monthly.
With both types of compounding, the interest you earn is usually calculated on a daily basis based on the end-of-day balance (the time cutoff varies by bank).
If you have $5,000 in your account on Monday, either type of account will calculate how much interest you are owed for the day.
If you move $3,000 out of the account on Tuesday, leaving a $2,000 balance, both types of accounts will use that new balance in their interest calculations for that day.
The difference is that for accounts that compound monthly, the interest owed for Tuesday will be calculated on just the $2,000 balance. For an account that compounds daily, interest will be calculated based on the $2,000 balance.
And also the interest owed from Monday.
Does it Matter?
As you’ve probably gathered by now, the difference between daily and monthly compounding is not significant. Unless you have hundreds of thousands of dollars in your account, the difference will be fraction of a penny.
While finding an account that compounds daily will give you a slightly larger return on your savings, it’s not significant enough to be a selling point when comparing banks.
Don’t Confuse Accrual and Compounding
One thing to remember is that you should not confuse accrual and compounding.
Almost every bank will only pay out accrued interest on a monthly basis when your statement period closes. That does not mean that all banks will compound your interest monthly.
Banks that compound your interest daily will, in effect, track two balances for your account. One balance will be the one that you can see, which is the amount of money available to you for withdrawal.
The second is that amount, plus any interest that you’ve had since the last time that interest was deposited into your account.
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When calculating how much interest is accrued each day, the bank will use the second number, which will be larger than your visible balance.
This is how the bank can compound interest daily without making daily deposits to your account.
Daily compounding of interest from your savings account might net you a few cents, but not much more. If a bank offers you daily compound interest you should not turn down the free money.
But keep in mind that daily compounding makes only a minimal difference in how much you can ultimately save.
As a consumer, you should understand that daily compounding matters far less than the interest rate being paid and any fees you may incur. So don’t overlook other bank account features in favor of daily compounding.
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