When you put money into an interest-bearing account, you expect your money to grow. And, the longer you save, the more your money will work for you. If you want to maximize your earnings, though, compound interest is the way to go.
Why is compound interest the best way to save?
One of the quickest and easiest ways to grow your savings is by using compound interest – or earning interest on the interest you’ve already made. Before we get into the benefits of compound interest, let’s take a look at the difference between earning simple interest and compound interest.
Simple interest is interest earned only on your principal or the original amount you invested. So, if you invested $1,000 in an account that earns simple interest at a rate of 2.00% each year, you would make $20. Each year your interest earnings would be exactly the same - $20. At the end of 40 years, you’d have $1,800 in your account.
Compound interest allows you to earn interest on your interest. So, if you take the same $1,000 invested in an account that earns 2.00% in compound interest, you’ll see a larger return than using simple interest.
Let’s take a look:
- After year 1, you’ll have $1,020 in your account (the same as simple interest).
- After year 2, you’ll earn interest on $1,020 for a total of $1,040.40.
- After 40 years, you’ll have $2,208.40 in your account (if you don’t add any more money to your savings).
As you can see, you’ll earn more (in this example, $400 more) using compound interest rather than simple interest. If you regularly contribute to your account, that amount will build even faster.
The Annual Percentage Yield (APY) and Compound Interest
The best tool to evaluate how much you’ll earn in any deposit or savings account is the Annual Percentage Yield (or APY) – it tells you how much you’ll earn in compound interest over one year. So, the higher the APY, the more you’ll make.
The APY will also take into account whether or not your earnings will be compounded daily or monthly. If an account offers daily compounding, that means interest earnings are calculated on your account daily. If monthly compounding is used, your earnings will be calculated monthly. For example, the APY for an account with a 2% rate is 2.02% with daily compounding and 2.01% with monthly compounding. As you can see, the difference is not significant unless you have a large balance in your account.
You'll find that compound interest is truly effective the sooner you start to save. That way, you’ll watch your money grow – without having to do much at all. Moreover, you’ll reap great rewards in the end.
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