Interest on a savings account is compounded, meaning that interest earned is added to the principal amount, and then interest is calculated on the new, larger principal. This process repeats over time, allowing your savings to grow faster than with simple interest.
Here's a breakdown of how compounding works:
- Initial Deposit: You deposit a certain amount of money into your savings account. This is your principal.
- Interest Period: The bank calculates interest based on your principal and the interest rate. This is usually done monthly, quarterly, or annually.
- Interest Added: The interest earned is added to the principal, creating a new, larger principal.
- Next Interest Period: The interest for the next period is calculated on the new, larger principal.
Example:
Let's say you deposit $1,000 into a savings account with a 5% annual interest rate compounded annually.
- Year 1: Interest earned = $1,000 x 0.05 = $50. New principal = $1,000 + $50 = $1,050.
- Year 2: Interest earned = $1,050 x 0.05 = $52.50. New principal = $1,050 + $52.50 = $1,102.50.
As you can see, the interest earned in each subsequent year is higher than the previous year because it's calculated on a larger principal.
Types of Compounding:
- Daily Compounding: Interest is calculated and added to the principal daily.
- Monthly Compounding: Interest is calculated and added to the principal monthly.
- Quarterly Compounding: Interest is calculated and added to the principal every three months.
- Annual Compounding: Interest is calculated and added to the principal yearly.
The more frequently interest is compounded, the faster your savings will grow.
It's important to note that:
- The interest rate offered on savings accounts can vary depending on the bank and the account type.
- Compounding can help your savings grow faster, but it's essential to compare interest rates and compounding frequencies across different banks to find the best deal.
