How does interest work on savings accounts—and how can knowing this help you earn as much as possible on the money you save?
Let’s say you have $1,000 in the bank, and it is earning 1% interest. In fact, until around 2018, 1% was far more than what most banks were paying in savings accounts due to historically low interest rates. But with rates rising, some banks are offering savings accounts that yield as much as 2.1%. But for the purpose of this story—which is all about compound interest and how it works—1% is a good round number to use as an illustration of how it works.
Interest Builds on Interest
In the simplest of worlds, $1,000 at 1% interest per year would yield, at the end of a year, $1,010. But that is simple interest, paid only on the principal. Money earns compound interest when the interest earned is added to the original deposit each time it is calculated. So in the case of a savings account, the interest is compounded, either daily (best) or monthly or quarterly, and you earn interest on the interest. The more frequently the interest is added to your balance, the faster your savings will grow. So with daily compounding, every day the amount that earns interest grows by another 1/365ths of 1%. At the end of the year, the deposit has grown to $1,010.05.
Okay, that’s a lousy nickel more. But at the end of 10 years, your $1,000 would grow to $1,105.17 with compound interest. Your 1% interest rate, compounded daily for 10 years, has added more than 10% to the value of your investment.
Yes, this is still depressing. But now consider what would happen if you were able to save $100 a month, and add it to that original deposit of $1,000. After one year, you would have earned $16.57 in interest, for a balance of $2,216.57. After 10 years, still adding just $100 a month, you would have earned $730.93, for a total of $13,730.93.
Still not a fortune, but it’s a reasonable rainy day fund. And that is the main purpose of a savings account. When money managers talk about “liquid assets,” they mean any possession that can be turned into cash on demand. It is, by definition, safe from fluctuations in stock-market or real estate values. In real-people terms, it’s the emergency stash.
You can try any variation of the above for yourself on this compound interest calculator.
The Snowballing Effect
To truly understand the snowballing effect of compound interest, consider this classic test case, conducted by none other than Benjamin Franklin. The scientist, inventor, publisher, and Founding Father was a bit of a showman, so it must have given him a chuckle to launch an experiment that would not bear results until 200 years after his death in 1790.
In his will, Franklin left roughly the equivalent of $4,500 each to the cities of Boston and Philadelphia. He stipulated that it was to be invested at 5% annual interest for 100 years. Then, three-quarters of it was to be spent on a worthy cause while the remainder was reinvested for another 100 years.
In 1990, Boston’s fund had about $5.5 million. Philadelphia had about $2.5 million. Due to the effects of compound interest, both cities managed to outperform the rate of inflation over the 200 years. However, neither city came close to the combined $21 million that Franklin calculated they would achieve. The reason: Interest rates fluctuated over time, rarely achieving the 5% annual rate that Franklin assumed.
Start Early, Save Often
Still, Franklin’s experiment demonstrated that compound interest can build wealth over time, even when interest rates are at rock bottom.
If you want to get started, you can find out the rates banks are currently offering by going online. Make sure that you focus on banks where interest on the account is compounded daily and no monthly fees are charged. Banks often state their interest rates as APY, or annual percentage yield, which reflects the effects of compounding. APY and annual percentage rate (APR) are not the same thing.
The Bottom Line
Unlike Ben Franklin, most of us have no desire to test what our money might be worth in 200 years. But we all need to have a little money set aside for an emergency. Compound interest, combined with regular contributions, can add up to a decent emergency nest egg.