Compound interest is one of the great powers of the financial world. Compound interest can help a 20-year-old become a multimillionaire by retirement age without having to save millions. Whether you dream of a comfortable retirement or building financial security, a compound interest savings account is one tool to help you reach your financial goals.
A compound interest savings account allows you to earn interest on the account’s principal and any interest accrued. Read on to understand what a compound interest savings account is and how it can help you reach your goals.
How a Compound Interest Savings Account Works
Compound interest savings accounts allow you to earn more and build savings over time. Here is how compound interest savings accounts work:
Initial Deposit
You start by depositing an initial sum of money into the compounding interest account. This step is the same for any bank account. See below for key features to look for when selecting a compound interest account.
Interest Accrual
The financial institution pays you interest on the amount you’ve deposited. Unlike simple interest, where you earn interest only on the initial deposit, a compounding interest savings account allows you to earn interest on both the principal (initial deposit) and the accumulated interest from previous periods.
Compounding Frequency
Compound interest can be compounded at different intervals, such as daily, monthly, quarterly or annually. The more frequently interest is compounded, the faster your savings will grow.
Growing Savings
As time passes, the interest you earn contributes to your overall account balance. This means your savings grow at an accelerating rate, especially if the interest is compounded frequently.
Long-Term Growth
Compound interest has a powerful effect over time, making it an effective way to build savings and accumulate wealth over the long term.
For example, if you save $1,000 in an account with a 5% annual percentage yield (APY), you’ll earn $50 in the first year. If you add that $50 to the $1,000, you’ll earn a little more the next year. Continue for 30 years, and your initial $1,000 could grow to over four times as much — over $4,000— without any additional deposits.
Key Features to Look for in a Compound Interest Savings Account
Understand the features to look for in a compound interest account to maximize savings growth. These include:
Competitive Interest Rates
Competitive interest rates in compound interest accounts are essential. Higher interest rates result in greater earnings over time. A compound interest account with 2% interest won’t grow much, even over 30 years, and likely won’t outpace inflation.
The impact of interest rates on the overall growth potential of savings or investments in compound interest accounts can make a huge difference in long-term wealth building. Taking the same example of $1,000 in a compound interest account for 30 years, 5% interest will lead to over four times the money. With 1% APY, the total after 30 years will only be $1,347.85.
Of course, with 11% interest — usually through investment rather than a savings account — the total could be more than 22 times the initial investment (over $22,000). Over your lifetime of savings, this is a huge difference.
No or Low Fees
Selecting compound interest accounts with minimal fees is important to maximize the overall return on investment. Common costs associated with compound interest accounts include account maintenance fees, transaction fees, overdraft fees and withdrawal fees. For example, even with 5% APY, fees can erode interest earnings and impact the growth of savings or investments. But many low-fees or no-fees compound interest accounts are available.
Minimum Balance Requirements
The purpose of minimum balance requirements for financial institutions is to assure the financial institution that you’ll maintain a certain balance so they can invest or lend funds. This can lead to higher potential returns. You might face fees or receive a lower APY if you don’t maintain the minimum balance.
Look at minimum balance requirements when assessing and selecting compound interest accounts. Then, choose minimum balance requirements that align with your financial situation and goals.
For example, if the bank only offers 5% APY if you keep at least $20,000 in the account, many people won’t be able to take advantage of the higher interest rate. But some accounts have high compounding interest rates and much lower minimum balances, like $100 to $1,000.
Accessibility and Convenience
Accessibility and convenience contribute to the overall user experience and satisfaction with the account. You don’t want to waste time trying to log in or have difficulty making a transfer.
When choosing an account, look for regular account features like easy access to funds without withdrawal limits or fees. Most compound interest accounts now have standard features like online account access and an app.
Look for desirable features in compound interest accounts, such as online banking, mobile apps, ATM access, electronic transfers and 24/7 customer support.
Account Insurance
Most protected compound interest accounts offer insurance to secure your funds. That’s because standard savings and checking accounts from banks and credit unions in the U.S. come with insurance of up to $250,000 per account holder and per bank.
When selecting protected compound interest accounts, first check that the bank is insured by the Federal Deposit Insurance Corp. (FDIC) or the credit union is insured by the National Credit Union Administration (NCUA). This is essential to protect your savings. Note that most investment accounts aren’t covered by FDIC or NCUA insurance. However, most compound interest savings accounts are federally insured.
If you hold compound interest savings accounts outside the U.S., most countries offer comparable insurance to safeguard account holders’ funds. For example, in Europe, the national Deposit Guarantee Scheme (DGS) guarantees that deposits up to a certain level will always be repaid even if the bank holding them fails.
Simple Interest vs. Compound Interest Accounts
The differences between simple interest and compound interest accounts come down to significant growth potential over time.
Simple interest is calculated on a bank account’s principal or original amount. Compound interest is calculated on the principal amount plus accumulated interest, so it’s like interest on interest. Simple interest doesn’t accumulate, whereas compound interest does. For long-term wealth-building, look for compound interest accounts.
It’s important to note compounding frequency as it affects the overall interest earned in compound interest accounts compared to simple interest accounts. Look for compound interest accounts with a higher compounding rate, like daily or monthly compounding, to maximize growth.
Optimizing Your Savings Strategy
Using compound interest accounts as part of your long-term financial growth strategy along with investment and retirement accounts, can build financial freedom. How much could you save over time? Use this compound interest calculator to start building a personalized savings strategy. Also, consider the best high-yield savings accounts and individual retirement accounts.
Frequently Asked Questions
What is a compound interest account?
A compound interest account pays interest on the principal plus any interest accrued. This allows interest amounts to compound over time.
How does compound interest work?
Compound interest works by compounding growth over time. Compound interest is exponential growth, which you could imagine as a snowball gathering momentum over time. In the same way, compound interest starts small, but as it compounds, wealth can grow.
What are the benefits of a compound interest savings account?
The benefits of compound interest savings accounts include long-term wealth building in a secure, federally insured account. With other wealth-building tools, a compound interest savings account can protect both short-term and long-term savings.
About Alison Plaut
Alison Kimberly is a freelance content writer with a Sustainable MBA, uniquely qualified to help individuals and businesses achieve the triple bottom line of environmental, social, and financial profitability. She has been writing for various non-profit organizations for 15+ years. When not writing, you will find her promoting education and meditation in the developing world, or hiking and enjoying nature.