If you pay interest on credit cards or other debt, or earn interest through savings accounts, the interest you are paying or receiving is likely being compounded by your bank. How often that interest is compounded depends on several factors, and the frequency can have an impact on your financial bottom line.
Compound Interest Defined
Compound interest is applied to previously accrued interest in addition to the principal. Compounding interest can be beneficial because it allows the principal to grow at a faster rate than it would normally. The impact of compounding depends on the compounding time period, which can be daily, monthly, quarterly semiannually, annually or continuously. If your money is compounded daily as opposed to quarterly, you'll be able to earn a better annual percentage yield (APY).
The frequency of compounded interest has the greatest effect on your savings. The more often interest is compounded, the more you earn. For that reason, interest that is compounded daily can grow your savings faster than interest that is compounded monthly or annually. Whether you've invested in a certificate of deposit or a regular savings account, do not hesitate to ask your bank how often they compound interest. Banks are required to disclose the frequency with which interest is compounded and credited, according to the Federal Reserve Board. Note that banks don't have to pay accrued interest if you close the account before the additional interest is credited.
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Example of Compounding
As an example of compounding, if you begin with a $500 investment where the interest is compounded annually and get 10 percent each year in interest, your investment will have grown to $665 by the third year. By the fifth year, you can expect your investment to be roughly $805. If it the interest is compounded semi-annually, it will be about $814 by the fifth year. If the interest is compounded quaraterly, it will be $819 a year by the fifth year. If it is compounded monthly, it would be about $822 by the fifth year. If it is compounded daily, it will be $824 by the fifth year.
Debt Interest Compounding
Just as the frequency of compounded interest can help you save, it can help lenders earn money. Among those that often compound interest on a monthly basis or more frequently are credit card companies and student loan providers. Before you take out any loan, you should understand how often the interest will be compounded. The more often interest is compounded, the more you will pay for a loan.