If you want to take charge of your finances, it's important to gain a thorough understanding of basic financial terminology. One common financial term you should take the time to understand is the concept of compounding. Compounded daily interest rates could be positive or negative for your finances depending on the situation.
What Does Interest Compounding Mean?
Compounding is the process of charging interest on the interest generated on an account. The compounding of interest continues on a regular basis. So instead of calculating the interest due based on the principal balance alone, the interest is calculated based on both the principal plus the interest earned over a period. If interest is compounded daily that means that the calculation occurs each day of the year (365 days).
Compounding interest may apply to your financial situation whether you're borrowing from a lender or saving money in an account. If you borrow money from a financial institution, the bank compounds your interest based on the balance you've borrowed and maintained on a daily basis. When you save money in an account like a CD (certificate of deposit), you receive interest payments (profit) based on the amount you've deposited. If you're the saver, getting daily compound interest is beneficial because the more frequently you compound, the more interest earned over time. It's not an ideal scenario if you're a borrower for the same reason (more interest expense).
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One common case where you might see a creditor use a compounded daily interest rate is when you open a credit card account. The creditor determines the account balance used (including purchases over the month) and then multiplies that amount by the daily rate (annual interest rate divided by 365) to determine the interest cost accrued each day. You can use an online calculator to find out the cost of a credit account that uses daily compounded interest.
Daily Compounding Example
It helps to do a daily interest compounding example by hand to truly understand the concept. Say you receive an annual interest rate of 4 percent on a savings account. The daily interest rate is about 0.005 percent (2 divided by 365). If you have an initial balance of $10 million on the first day of the cycle, the interest earned is $500.00 (0.005 percent times $10 million). The next day you'll multiply the new balance of $10,000,500 times the daily interest rate to get the new interest gain of $500.03. The third day you'll have a balance of $10,001,000.03 with an interest gain of about $500.05. Repeat that calculation daily — the amount increases each day.