We all want to make our money grow as much as possible. Some invest in their business, others in stock, and many in bank accounts.
One of the easiest ways to make money is by opening a compound interest account. With the power of compounding, you can earn interest on top of interest. Because no work is involved on your part, compound interest accounts are a great way to strengthen your financial position.
In this article, you’ll learn what compound interest is, how it differentiates from simple interest, and how to calculate it.
What is Compound Interest?
When you start an investment, let’s say a savings account, you can win extra money, called interest. This is a percentage of the money in your account. With compound interest accounts, interest is earned on principal and interest.
Principal and interest: the principal is the original amount you deposited into your account, while interest is the extra money you’ve earned. So “principal and interest” refers to the whole ammount, not just what you deposited.
In other words, with a compound interest account, you can win more money faster.
As months or quarters go by, you start to earn interest on multiple interest payments. Because of this interest-on-interest action, the account begins to sort of snowball and grow faster than with simple interest.
Compound Interest vs. Simple Interest
A simple interest account, interest is only earned on the principal. Unlike compound interest accounts where you earn in on the principal and interest.
Let’s say you have $700 on your account, and last month your account earned $7.15 in interest. With a compound interest account, you’ll be earning interest on $714.15 (with a simple interest account, you’d only earn interest on $700). Every time you get distribution in a compound interest account, you’re earning interest on both principal and interest.
Distribution: in this case, it’s when you get paid the interest.
The most common type of simple interest is the traditional bond. It pays interest payments semi-annually. These credits are not added to the principal (or face value) of the bond.
For example, let’s say you buy a bond with a face value of $1,000. It has a coupon rate of 3%. That’s the interest you’ll be earning every year. On a $1,000 bond, it’s $30. You get a $15 payment every six months. That payment can be sent to you as a check, or maybe it’s deposited into your brokerage or savings account. However, you receive it; it’s not added to the $1,000 principal. Thus, the bond doesn’t pay interest on interest payments.
Compound interest accounts: APY and APR
Financial accounts will often distinguish between Annual Percentage Yield (APY) and Annual Percentage Rate (APR). The first one, APY, factors in the impact of compounding.
If the compound interest account pays interest at least twice per year, the APY will be higher than the APR.
APY is a more accurate picture of how much money can be earned in an account because it factors in how frequently interest is paid. Some compound interest accounts will compound interest daily, while others will use a weekly or monthly schedule.
Read the fine print on any account before you open it. A few compound interest accounts will use a quarterly, semi-annual, or annual schedule.
The more frequent the compounding, the higher the APY, and the more money you’ll make.
What Kinds of Accounts Have Compound Interest?
Most banks offer compound interest accounts. Some brokerage firms offer methods that allow for compounding, but not all do. Here are some examples:
The vast majority of savings accounts will pay interest back into your account, allowing you to earn interest on the interest payments.
Live Oak Bank, for example, currently offers a business savings account that pays an interest rate of 1.09%. Interest is compounded daily, and this schedule produces an APY of 1.10%.
Some checking accounts don’t pay any interest at all. Obviously, these won’t offer any potential for compounding. But other checking accounts will offer compound interest.
For example, Axos Bank has a business checking account that pays a 0.80% APY with several perks, including a mobile app and an ATM card with fee refunds.
When you open a small business bank account, you want to earn the highest possible return. Remember that you have to keep up with inflation and pay taxes on the interest you earn. Compounding over the long term is a powerful force. But keep in mind that if you make withdrawals, you will reduce its effect.
Investment accounts are a different breed. Instead of depositing money in a bank with a guarantee on your principal, you invest in securities (these are things like stocks, bonds, and mutual funds). Their prices could go down, which means it’s possible to lose money in an investment account. In return for taking on this risk, you get a higher potential return.
Most securities pay cash distributions into your brokerage account. Thus, you wouldn’t normally expect to compound from securities. However, sometimes it’s possible to reinvest cash distributions into the securities that pay them. Most mutual funds offer this service, for example.
While stocks and exchange-traded funds don’t offer reinvesting of cash distributions, some brokerage firms offer something called a Dividend ReInvestment Plan. With a DRIP, cash distributions are converted into additional shares of stocks and ETF’s by the broker. Using this service, you can earn cash distributions on top of cash distributions, which is a form of compounding.
How to Calculate Compound Interest
To calculate an account’s APY, you can use this formula:
The interest rate is represented by r. And n stands for the number of compounding periods per year. Typically, this will be 1, 2, 4, 12, or 365. If n equals 1, the interest rate and the APY will be the same.
To figure out how much interest an account will earn over a specific time, you can use this equation:
E is the account’s ending balance, S is the starting balance, r is the interest rate, t is the total number of years, and n is the number of compounding periods per year.
While you can plug in the numbers and do the math, you’ll probably find it easier to use a calculator, an online calculator, or a spreadsheet. These will do the math for you.
- This online calculator at Investor.gov is a user-friendly tool that will show you how much interest your account will earn.
- And this tool at omnicalculator.com will calculate APY based on an account’s interest rate and compound frequency.
Compound Interest in the Real World
Let’s take the following example of Miguel, who owns a roofing company. He opened an online business savings account with an initial deposit of $1,000. Every month, he contributes an additional $500.
The account has an interest rate of 0.95% and compounds interest every day.
What is the account balance at the end of two years?
The equation we looked in the previous section doesn’t take into consideration Miguel’s monthly deposit of $500. But the online calculator at Investor.gov does. With the online calculator, we determine the ending balance is $13,133.75. The total amount of Miguel contributed was $13,000. He earned $133.75 in interest.
Start Compounding Interest!
Compound interest accounts can provide your business with the assistance it needs to grow. The best part of all is that money can snowball in these accounts without any work from yourself.
Besides compound interest accounts, a business loan could provide the financial aid you need. Camino Financial operates on the principal, “No Business Left Behind.”
Our user-friendly online application makes the process of getting the funds you need quick and easy. So don’t wait anymore and start growing your business!