Saving money can be a challenge, even more so for those whose wages and earnings have not kept pace with cost-of-living increases. In fact, a survey in early 2022 found that 56% of Americans would not be able to cover a $1,000 emergency with savings. Furthermore, saving is now at higher risk of losing purchasing power due to rising inflation.
There’s one powerful savings tool that can work to your advantage: compound interest. It can help you outpace inflation, and even grow the money you’re already saving in an exponential way. Let’s take a deeper dive into compound interest, and how it can best help you to achieve your savings goals..
What is Interest?
Albert Einstein once said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
This couldn’t ring more true today. In the world of personal finance, compound interest has catapulted savings for even an average earner. To start, let’s take a look at two types of interest: simple interest and compound interest.
At its most basic level, interest is the cost or compensation to borrow your money. If you think about it in real-life terms, there is a good chance that you are paying someone to borrow money. Examples include your mortgage, an auto loan, or a credit card. But the reverse logic is that institutions are paying you for the same service.
That is precisely what happens when you place your money into an interest-bearing savings account. Financial institutions will pay you a certain percentage of your principal balance to borrow your money. This is known as simple interest. Alternatively, you may pay simple interest on certain types of loans, such as auto loans or short-term loans.
Here’s an example: Imagine you have $1,000 in a savings account that earns 1% per year in interest. After the first year, you continue saving an additional $1,000 per year for five years. At the end of the five years, you will have accumulated $60 in interest ($10 per year) for a total savings of $6,060. So far, you have only made money on the principal.
Compound interest takes the simple interest concept up a notch. Rather than just making money on the principal in your account, you are earning interest on your savings plus on the accumulated interest from previous periods.
Here’s an example of how compound interest works: Imagine you start with the same $1,000 in a compound interest savings account that pays 1% interest per year. You then save $1,000 per year for the next five years. At the end of the savings period, you would have $6,204. In the first year, you would earn $10 on the first $1,000. In the second year, you would earn 1% interest on $2,010 instead of $2000, because the earned interest now also earns interest.
As you can see, the interest compounds exponentially. The more years you earn compound interest, the larger the gap between simple interest earnings and compound interest earnings.
It’s important to understand which perspective favors simple interest vs. compound interest. Simple interest is undoubtedly in your favor when you are the borrower. Conversely, compound interest is ideal if you are a regular saver.
How is Compound Interest Calculated?
Annual Percentage Yield (APY) indicates the total interest you earn on a deposit account over one year. The interest can be compounded (depending on your account, institution, and terms) daily, monthly, quarterly, or annually. A higher frequency of compounding generally equates to better growth of your savings account.
The APY may be either fixed or variable. With a fixed-rate account, the interest remains constant and does not change. With a variable-rate account, the interest rate is subject to fluctuation, which is usually determined by several variables, including:
- Supply and demand of savings accounts: When financial institutions require additional capital to give out loans, increasing the interest rate is a great way to encourage more people to deposit their money into savings accounts.
- Government influence: To help manage the economy during a downturn, the Federal Reserve will lower interest rates to encourage more spending in order to boost the economy. The lower the Fed rates, the lower the interest rates can be for the saver.
Additional Factors Affecting Interest Earned
First, if you want to maximize the interest you earn, you should make note of any fees associated with the account. Depending on the financial institution, it is possible that the fees you pay could be more than the interest you earn! Fees like overdraft protection, ATM fees, and monthly service charges can all detract from what you earn in interest.
Also, the more frequently you deposit, and the higher balance in your account, the more interest you earn over time. Compound interest takes a greater effect the longer you save, even if your savings amounts aren’t as substantial as you’d like. Consistent deposits over a long period of time are crucial to leveraging the power of compound interest savings accounts.
You may also want to concentrate a larger amount of your savings in savings accounts that offer the highest interest rates, rather than keeping money spread across several savings accounts.
Types of Compound Interest Accounts
Savings accounts aren’t the only type of account that pays compound interest. Other options, which differ in rate structure, terms, and flexibility, include the following:
- Checking Accounts
- Certificates of Deposit/Share Certificates
- Money Market Accounts
Note that not all financial institutions offer interest compounding on the abovementioned accounts. By doing some research, you can determine which ones do offer it and how they are structured. Typically, the more stringent an account is, the higher the payout will be (e.g. you can often earn more on a CD versus a standard savings account, but are required to keep your money put for a specified period of time).
Benefits of a Compound Interest Account
Compound interest savings accounts come with a host of different benefits and challenges to be aware of. Some of the benefits of a compound interest savings account include:
- They can increase your balance(s) substantially
- They are easy to open
- They are easily accessible
Balance Growth Potential
As mentioned above, the power of compounding interest is undeniable. The more years you earn compound interest, the more you will see exponential growth. Long-term this can add substantial dollars to your finances.
Easy to Open
Opening an account is not difficult to do. In fact, you can open one with a relatively low barrier to entry. Depending on the institution, you may be able to open an account over the phone, online, or in person if you meet the required eligibility.
As an added benefit, you have the comfort of knowing that your money will remain secure, even if the financial institution fails. Credit union balances up to $250,000 are protected and insured by the National Credit Union Administration (NCUA). At a bank, the Federal Deposit Insurance Corporation (FDIC) will insure your deposits up to $250,000.
Easily Accessible (Savings Accounts)
You have the option of accessing the funds in your savings account at a moment’s notice. Savings accounts are typically highly liquid, which is important for emergency funds and other short-term savings goals. Unlike other financial products that lock your money in over a certain period, like a bond or certificate of deposit (CD), keeping your money in a compound interest savings account gives you direct access while earning interest.
Limitations of a Compound Interest
Knowing the limitation before opening an account can help you come up with the right solution to make the most out of your hard-earned money. Some limitations associated with compound interest accounts include:
- Low interest rates
- Limited transactions
- Taxable interest
Low Interest Rates
Interest rates on traditional savings accounts are often lower than other types of deposit accounts. According to the FDIC, the national average APR on regular savings accounts is 0.06%. Depending on the type of account you choose, it will be important to start your depositing early and often to benefit from compound interest.
Remember the factors that influence earning interest. You can shop wisely when choosing a savings account that is right for you. High-yield savings accounts or savings accounts from your local credit union often have higher interest rates than traditional banking institutions.
While your money is easily accessible, you need to be mindful of the number of transactions you can do within your savings account during a given period. Some banks may allow you to deposit at will, but limit the number of withdrawals you make. Occasionally, making too many withdrawals within a certain period of time can result in additional fees per transaction.
Interest Is Taxable
Similar to investment products, the interest earned within your savings account is considered taxable income. You will have to report any interest earned (over a certain amount) on your taxes, regardless of whether or not the money stays in your account, is withdrawn, or is transferred. You will receive a Form 1099-INT for any interest accrued in the account over $10 per year.
Most long-range financial goals require a combination of vehicles to achieve. The right college savings strategy for you will depend on a variety of factors unique to your family. Knowing your options and working with financial professionals will help you solidify a plan that you can trust is moving you in the right direction.
Take Charge of Your Savings with Lafayette Federal
At Lafayette Federal Credit Union, we offer many tools and resources to support the financial well-being of its members. We work with our members to provide the financial assistance they need to succeed — including setting the groundwork for a successful savings plan..