How compound interest on a savings account works

One of the best parts of opening a savings account is watching the money you deposit grow over time, thanks to interest.

Savings accounts typically grow with compound interest — that means you earn interest both on the amount you’ve saved and any interest you previously accrued.

Let’s take a look at how compound interest works and factors that can affect how quickly your money grows.

1. What is compound interest on a savings account?
2. How often does a savings account compound interest?
3. How do you calculate compound interest?
4. Factors that affect how much interest you earn
5. What’s next?

What is compound interest on a savings account?

You may have heard of interest on a credit card or car loan — that’s the cost of borrowing money from a bank or lender — and it’s expressed as a rate.

On the flipside, when financial institutions borrow money from you, they pay you interest. They typically pay interest on deposit accounts — such as savings accounts, checking accounts and money market accounts — in exchange for the ability to use your money until you need it.

Savings accounts can earn interest one of two ways: through simple interest or compound interest. With simple interest, you earn interest only on your principal — the amount you’ve deposited into your account.

But compound interest allows you to earn interest on your principal and the interest you’ve already earned.

Let’s say your bank compounds interest on your account every month. After the first month, the bank pays interest on the principal. The next month, the bank pays interest on the principal plus the previous interest you earned. From there, the interest continues to accumulate each month on the combined amount of your savings and interest earned.

In general, you’ll earn more on an account with compound interest than on one with simple interest.

How often does a savings account compound interest?

Depending on your financial institution and the account, interest can compound daily, monthly, quarterly or annually. The more often interest compounds, the faster your balance will grow.

The amount of interest you earn each year, based on the total amount of interest earned and how often interest is compounded, is expressed as the annual percentage yield, or APY. The more frequently interest is compounded, the higher your APY — and therefore, your interest earnings — will be.

How do you calculate compound interest?

An online compound interest calculator can help you crunch the numbers, but you can also do the math yourself. Here’s the equation for calculating compound interest.

Image: svcompound

Here’s an example to help you figure out the future value of your savings account.

Let’s say you open an account with an initial deposit of $2,000 (this is your principal, or P). If your annual interest rate is 2%, then R = 0.02. If your bank compounds interest once a month, N = 12 here. Let’s say you want to calculate how much you’d have in savings after two years (T = 2).

Your calculation would look like this.

A = 2,000(1+ 0.02/12)^{(12 x 2)}

At the end of two years — assuming you haven’t withdrawn or made any deposits to the account — you’d have $2,081.55. Your original deposit was $2,000, so you would’ve earned $81.55 in interest.

Factors that affect how much interest you earn

A range of factors can influence how much interest you can earn — and how quickly you earn it. Here are a few.

The amount of money in your account

Generally, the more money you have in your savings account, the more interest you’ll earn over time. Making recurring deposits means you’ll earn interest on a larger balance, while withdrawing money means you’ll accrue interest on a smaller balance. In other words, it pays to keep the money in your account.

Your interest rate

Your APY may change over time, especially if the Federal Reserve raises or lowers the federal funds rate, so be sure to pay attention to any rate changes.

How frequently your financial institution compounds interest will affect how much you earn, too — another reason why comparing APYs across savings accounts is important.

Account fees

While account fees won’t change the amount of interest you earn, they could offset your earnings — or, worse yet, you could end up paying more in fees than you earn in interest. Depending on the institution and the account, you might pay a monthly maintenance fee or fees for exceeding your withdrawal limit, requiring overdraft protection or using an ATM, among others. Banks usually offer workarounds to avoid some monthly fees, such as keeping a minimum balance, so read all the terms before opening an account.

What’s next?

Whether you’re saving for a car down payment, building an emergency fund or working toward another savings goal, a savings account with compound interest could be a good place to stash your money. The interest works in your favor, and you can access the funds in a pinch.

To help find the best savings account for your financial goals, shop around and compare APYs and terms from a range of institutions. Keep in mind that some online banks may offer higher rates than brick-and-mortar banks or credit unions.

You might also consider a high-yield savings account, which offers a higher interest rate than traditional savings accounts. Just make sure the bank, credit union or other depository institution is insured by the FDIC or NCUA, and pay attention to the fine print, such as minimum deposit or balance requirements, how often the interest compounds, and any fees — details that can affect your rate of return in the long run.