Remember that old movie line, “I wish I had a dime for every dime I had”?
Whether you’re adding money to a high-yield savings account or socking it away in a certificate of deposit (CD), you want it to grow. That’s where compound interest comes in. It’s a simple—yet powerful—tool for making your dollars and cents add up faster.
What is compound interest?
The easiest way to think of compound interest is this: it’s interest you earn on your initial principal and your accumulated interest.
For example, say you deposit a set amount of money in a savings account or CD. Your initial deposit earns interest, then each time the interest compounds, you earn interest on the principal and on the interest you’ve already accrued. Sounds good, right?
Interest can be compounded daily, monthly, quarterly, or annually, depending on where you’re keeping your savings. The more often interest compounds, the faster your money grows.
Compound interest is different from simple interest, which is a set percentage of interest you earn on a deposit account each year.
How to calculate compound interest
For math lovers, there’s a specific compound interest formula you can use to calculate compound interest on savings. It looks like this:
If that seems too complicated, the easiest way to calculate compound interest is to plug the numbers into a compound interest calculator like this one. With a calculator, you’ll easily be able to see how interest compounded daily compares with interest compounded annually or monthly. The great thing about using a calculator is that you can run different scenarios to see how much interest you can earn, based on different compounding frequencies, interest rates, and deposit amounts.
How compound interest impacts your savings
Compound interest helps you grow your money and it can make a huge difference, whether you’re saving large or small amounts.
Let’s look at the following example of a $1000 initial deposit (amounts rounded to the nearest dollar):
In this example the amounts are small, but you get the idea. With larger deposits over a longer period of time, that compounding effect can really add up.
What determines compound interest?
As you can see from the examples above, the interest rate is a major factor in calculating compound interest, but it doesn’t tell the full story. When you’re shopping around for a savings account or a CD, for instance, you should compare the APYs. The APY, or annual percentage yield, gives you a better idea of your potential earnings because it takes the frequency of compounding into consideration.
At Ally Bank, we compound interest daily, which can give your savings an advantage over deposit accounts that compound interest just quarterly or annually. That means, in time, you really might just have a dime for every dime you have.