When you deposit money in the bank, you are paid a certain amount of interest. That interest keeps on adding to your bank and you are paid interest on that interest over time from your bank, which is known as compound interest. It helps in growing your money over time. This growth is dependent on three factors that include the rate, the balance in your account, and how many times the bank will pay you the compound interest.
How do we get compound interest?
Suppose your bank account stands at $5000 and the rate for interest is 0.55% APY, the bank provides compound interest on a monthly period. Now, if you deposit $100 monthly into your account then at the end of the third year the balance of your account will stand at $8,714. In 1 year, that deposit will amount to $5100 in the account.
On the other hand, if you do not make any monthly deposit, your balance will reach only $5,028 at the end of 1st year. Then you will be provided interest on both $28 and the $500 on the initial amount.
You can get compound interest, if your account offers returns, to earn higher interest, you should look for high rates that provide the best benefits. The national average rate stands at 0.06% APY, but many online banks offer interest rates higher than that. For instance, a rate that is 5 or 20 times more than 0.06%.
The rate of interest is volatile, as the banks reserve the right to lower or raise this interest at any time. If you are more leaning towards getting interest at a fixed rate, then CDs (Certificates of Deposits) will be the ideal choice for you.
Simple interest vs compound interest
When the interest is paid on the principal amount by the bank, to calculate the simple interest, all you have to do is multiply the interest rate with the time that you wish to accrue interest for. Make sure you only take the original amount into account for simple interest.
Compound interest is when you earn interest on the original amount as well as the interest that you earned. You can withdraw this amount from your bank, but leaving it will reap more benefits, and also help increase the initial amount.
For example: A bank having an APY of 0.55% will provide $27 interest on an amount of $5000. But if we compound it monthly, it will lead the interest to be 27.57, this amount may not seem very big, but in the long run, it will increase by leaps and bounds.
Accounts that provide compound interest on a daily rather than monthly period also exist. Some examples of such banks are Markus by Goldman Sachs and American Express.
How to calculate compound interest?
To compute the compound interest of 12 months, this formula is applied.
A = Ending amount
t = Time frame
P = Original balance
n = Number of times interest is compounded for a certain period
r = Interest rate (as a decimal)
To calculate the interest, you need to know these values and put them in their respective place in the formula. To choose the best bank, you can take their interest rate and compare it with different ones. Interest is a good way of earning money without worrying about putting in the effort. All you need to do is be consistent with deposits and withdraw only when it is a genuine urgency.