Compound interest is a great way to make your money work harder for you, and can help you reach your savings goals sooner. Here’s how compound interest can help you earn a lot more interest on your savings balance.
What is interest?
Similar to the interest you pay on a loan, you can also earn interest on the money that you’re lending to the bank. Interest is the money the bank pays you as a return for depositing money with the bank. A number of factors affect the amount of interest you receive:
- The interest rate
- Method of calculation
- Payment frequency
The interest rate is normally stated as an annual percentage — the higher the rate, the more you earn.
What is compound interest (and why is it important)?
Interest is usually calculated using the simple-interest method and the compound-interest method:
- Simple interest. Calculated based on the initial principal of a loan or deposit. For example, a $100,000 fixed deposit with a 1% p.a. interest would mean that you’d receive $1,000 if it’s calculated on simple interest basis.
- Compound interest. A percentage calculated based on the both the initial principal amount and accumulated interest from previous periods. This is also known as interest-on-interest.
Since you’re earning interest on the interest you’ve previously earned (which is added onto your principal balance) with compound interest, it’ll bring about exponential growth on your initial capital. The longer you save, or the higher the compounding frequency, the more interest you will earn over a specified period of time.
Your balance will also continue to grow even if you don’t deposit any extra money into your account. This is the effect of compounding – one of the most powerful forces in finance.
What is compounding frequency?
Interest can be compounded on any given frequency schedule, from continuous to daily to annually.
- Annual compounding. Interest is calculated and paid once a year.
- Quarterly compounding. Interest is calculated and paid once every three months.
- Monthly compounding. Interest is calculated and paid every month.
So when interest is compounded at a higher frequency, the final value for that will be higher compared to one with fewer compounding periods. This is assuming that all else stays the same.
How do the banks calculate compound interest on my savings account?
Interest is typically calculated on a daily basis on the daily closing balance. Here’s the equation on a savings account:
Daily closing balance x interest rate (as a percentage) / 365
Interest begins to accumulate on the day the opening deposit is made in your savings account. It’s then usually credited into your account on the last day of each month. If you choose to close your account, your accrued interest will be deposited on the day it’s closed.
Any interest awarded to your savings account is usually available for use on the same day it’s been credited. The daily closing balance of your savings account tends to include all cleared and uncleared transactions. This may be because electronic transfers to your linked bank account usually occur on a business day.
How does compound interest work in technical terms?
A savings account with compound interest is applying the interest to interest that has already been paid to you. This occurs with accounts where interest is paid directly into the account on an on-going basis. This differs from what is referred to as simple interest, which is only paid into the account at the end of a specified term, even though it is being calculated on the daily balance.
There is a formula that can assist you in seeing how beneficial compound interest can be to your savings:
- A = the future value of the entire investment, including the earned interest
- P = your initial deposit amount or principal investment
- r = the interest rate annually as a decimal point
- n = how often interest is compounded each year
- t = the number of years the money is invested for
In most cases the interest will be compounded monthly, or 12 times in a year if you are looking at a standard savings account, and annually if you are trying to calculate the interest earnings on a long term term deposit.
How much compound interest you'll earn on a $5,000 initial balance
To better understand the benefit of compound interest, say John invested $5,000 into a standard savings account that is paying interest at a rate of 3.5% per annum (p.a.) compounded for 5 years. Interest is being calculated daily, and the payments are being made directly into the account once a month:
If John continues at that same rate for next five years, he will earn a total of $954.71 in interest, yet if he had chosen an account which pays interest once a year, the total earnings would be $938.43 after five years.
Alternately, this is how interest earnings would look after five years in an account where interest is paid annually:
In this example, we assume that you did not make any withdrawals or have any fees deducted from the balance during that time period. Adding or withdrawing from the balance will also change your results.
What are the pros and cons of compound interest?
While it may seem like choosing an account with compound interest should be your only option for maximum benefit, there are other things to take into consideration:
- Account accessibility. The majority of savings accounts in Singapore that provide compound interest do so without any set terms. These on call accounts allow you to make withdrawals and additional deposits whenever you need to.
- Bonus rates. You can find savings accounts with compound interest that do give you an incentive of bonus interest for not making any withdrawals in a month. This encourages you to save, yet still gives you access to your money easily in case of an emergency.
- Increased interest income. With compound interest, your earnings are being increased exponentially, as each month the interest is being calculated on a slightly higher balance.
- Lower rates. The drawback to earning compound interest is that the annual rates are sometimes not as high as accounts like term deposits where interest is not compounded monthly.
- Accessibility. Some may find that having open access to savings can pose as a discouragement, as you can easily dip into it for daily needs, causing you to lose a portion of your interest earnings.
How do I make the most of my compound interest?
In order to receive the maximum benefit from an account with compound interest, you should:
- Start early. saving as much as possible at the soonest
- Restrict the number of withdrawals. The more money that is in your account at the end of the month, the more interest you will earn, and the more interest you earn means you will earn even more interest the following month.
- Avoid losing out on bonus interest. If you are earning compound interest with an account that has terms for bonus interest, be diligent about meeting those terms each month.
- Look out for any fees. Many savings accounts require that they be linked to your transaction account in order to put money in and take money out. Look at the features of these transaction accounts as well, and make sure that you are not paying excessive fees each month.
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