Compound interest allows you to earn money on your savings. While a traditional savings account with simple interest earns money on your deposits, compound interest savings accounts allow you to earn money on the interest you earn as well. The same rule applies to interest on loans, including mortgages – and in that case, compound interest means the lender earns more.
Our Addition Financial members often come to us with questions about compound interest. One of the most common questions we hear is this:
“What difference does it make if interest is compounded daily, weekly or monthly?”
That’s an important question to ask and we want to make sure that you make the most of compound interest to grow your savings as quickly as possible – and to minimize the amount of interest you pay to lenders. With that in mind, here’s what you need to know about compounding periods and the difference they can make in your earnings.
Daily Compounding
Daily compounding indicates a situation where interest is calculated and added to your balance daily. That can either work in your favor or against you depending on which side of the interest formula you sit.
Let’s start with the good news. If you put money into a compound interest savings account that compounds daily, your savings will grow daily. The amount may be small at first but over time, it will increase. For purposes of simplicity, we will illustrate each compounding period assuming that no money is coming in or out of an account.
For example, if you had $5,000 in a money market account with an interest rate of 5% that compounded daily, you would earn $0.68 in interest your first day. The following day, your daily compounding would be calculated using your new balance of $5,000.68 and earn you interest of $0.69, giving you a new total of $5,001.37. (You can calculate the daily interest rate by taking the annual rate and dividing it by the number of compounding periods in a year; in this case, that number would be 365.) At the end of one year, your new balance would be $5,256.36.
With a loan, the daily compounding interest would add to the amount of interest you owe. So, if you took out a $300,000 mortgage with a 1.75% interest rate, the interest for the first day you owned your home would be $14.40. That number would then be added to your balance and the next day’s compound interest would be calculated off the new total. Your payments would affect the balance and thus, also affect the amount of daily interest you accrue.
With saving, it makes sense to leave your money in the compound interest account where it will grow daily. With a loan, you may want to consider making extra payments toward the principal to reduce the amount of total interest you will pay over the term of the loan.
Weekly Compounding
Some savings and investment accounts compound weekly instead of daily. Instead of dividing your annual interest rate by 365, you would divide by 52. At the end of one week, your new balance would be $5,004.81 and at the end of a year, it would be $5,256.23. As you can see, the change from daily to weekly compounding means that you’ll earn $0.13 less in your first year. That’s not much, but the differences will increase over time.
If you had weekly compounding on a loan, the same principle applies. You would pay slightly less in your total interest amount with weekly compounding. Using the same example as above, on a loan of $300,000, after one year of daily compounding, you would accrue $5,302.18 of interest. With weekly compounding, that number would be $5,295.33. Again, not a huge difference but the value becomes significant over time.
Quarterly Compounding
Now, let’s move onto quarterly compounding. You are extremely unlikely to get a loan with quarterly compounding, but we’ll run through the numbers anyway, so you can get a feeling for how it works. Quarterly compounding involves adding interest once every three months.
If you take the same $5,000 deposit in a compound interest savings account with 5% interest, your balance would be only $5,254.73 at the end of one year. As you can see, the differences become larger the fewer compounding periods there are per year. In this instance, you would earn $1.64 less than you would with daily compounding.
On a loan, you’ll notice the same effect. With a $300,000 loan at 1.75% interest, the accumulated interest value would be $5,285.55 after one year. You can see that you’re now saving $16.63 in interest.
Annual Compounding
The final option is annual compounding, which means interest would be added to your balance only once per year. In such cases, the calculation is simple. You would take your initial balance, multiply it by the annual interest rate, and add it to your balance. The following year’s interest would be calculated off the new balance assuming that your balance stayed the same.
For our sample savings account, that would mean that your $5,000 balance would turn into $5,250 at the end of the year. That’s $6.36 less than you would have earned with daily compounding. The larger your balances are, the more money you could lose out on with your balance being compounded annually. (It’s worth noting here that annual compounding gives you the same earnings as simple interest in the first year, but it increases with each subsequent year.)
With a loan balance, the same thing would happen. Instead of accruing $5,302.18 of interest, you would accrue only $5,250.00 of interest for savings of $52.18.
Which Type of Compounding is Best?
By now, it should be apparent that the type of compounding frequency that is most advantageous to you as a consumer depends upon where it is applied. For a savings or investment account, daily compounding will allow you to earn the biggest amount on your savings and make it possible for you to accrue money as quickly as possible.
The reverse is true for a loan balance or debt. Daily compounding causes interest to accrue more quickly than it would with fewer compounding periods. Over the life of your mortgage, a difference in compounding frequency can cost you thousands of dollars in additional interest. Most mortgages have daily compounding, so in the next section, we’ll talk about some tips to help you make the most of interest compounding in its various forms.
How to Make the Most of Compounding
If you want to save money and build wealth, then having compounded interest in your accounts can help you do it – particularly if you’re happy to leave your money alone and allow it to continue to earn interest.
The key thing to remember when shopping for a savings account is that you’ll need to check the following things:
- The interest rate
- The annual percentage yield (APY)
- The compounding period
Most of our experts agree that you shouldn’t settle for anything less than a 1% APY on a regular savings account and daily compounding is preferred. However, depending on how much access you need to your money, you may want to consider opting for a money market account with a higher interest rate.
You can maximize your savings in any compound interest account by making regular deposits to increase your balance and leaving the money alone. As your balance increases, so will your earnings.
With a loan, getting a low number of compounding periods per year can help you to save money by paying less interest. However, most lenders default to daily compounding for large loans such as mortgages and car loans.
For that reason, it may not be possible to find a mortgage with weekly compounding, and it’s likely to be virtually impossible to find anything with quarterly or annual compounding. But, that doesn’t mean you can’t save some money.
Here are some options to help you save money on interest with daily compounding:
- Opt for a shorter loan term if you can afford it. 30-year mortgages are the standard, but if you can afford a higher monthly payment, you can save thousands of dollars in interest by opting for a 20-year or 15-year term.
- Pay extra toward your principal balance every month. If your lender allows it, even throwing an extra $50 or $100 each month can help you to pay down your principal balance more quickly and save money on interest.
- Another option is to make one or two extra payments per year. You may want to time them to line up with the months when you get an “extra” paycheck if you get paid every other week, or with when you get your annual bonus.
The most important thing to do is to be aware of how different compounding periods can impact your savings and debt, and then do what you can to protect yourself by earning more and spending less.
Compounding interest periods can have a significant impact on your savings and growth as well as on your debt. Any time you open a new account or borrow money, you should ask about compounding and make sure you understand it before you proceed.
Are you looking for help with managing your money? Click here to schedule an appointment with one of our Financial Professionals today!
Posted on Aug 19, 2021
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