What Is a Compound-Interest Savings Account?

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Definition

A compound-interest savings account earns interest on the principal balance and accumulated interest, allowing you to grow your savings more quickly than if you’re only earning interest on the principal.

How a Compound-Interest Savings Account Works

A compound savings account is an interest-earning savings account that calculates your interest earnings based on the principal and past interest you’ve earned. Accounts with compound interest typically have an annual percentage yield (APY). The interest rate you earn depends on a variety of factors, including the amount and the type of account you opened.

Note

When you deposit money into a savings account, banks usually lend that  money to other customers. In the meantime, the bank pays you an interest rate that’s lower than the rate it charges other customers to borrow the money.

Typically, a deposit account earns either simple or compound interest. A simple-interest account pays interest on the principal amount. A compound-interest savings account earns interest on the principal balance and interest.

How To Calculate Compound Interest

If you want to figure out how much you can expect to earn in compound interest, an online calculator works. However, you can also calculate this amount on your own using this formula:

A=P(1+r/n)nt

A = Amount of interest earned

P = Principal balance

r = Interest rate

n = Number of times interest is applied per time period

t = Number of time periods elapsed (in months or years)

Note

The rate at which your interest is compounded can affect how much interest you pay on a loan or credit card as well. For instance, if you have outstanding credit card debt and the interest is compounded daily, your debt will grow quicker.

Example of a Compound Interest Savings Account

How frequently your interest compounds impacts how much interest you earn. That’s why it’s important to know if your interest compounds daily, monthly, quarterly, or annually.

Let’s say you deposit $1,000 into a savings account that earns a 1% annual percentage yield (APY) and compounds every quarter. In the first quarter, you’ll earn $2.50 in interest on your principal balance. The next quarter, you’ll earn interest on $1002.50 instead of $1,000.

Note

The interest rate you earn can significantly affect how quickly your savings grow. Online banks typically offer higher interest rates than traditional banks.

Types of Compound-Interest Savings Accounts

High-Yield Savings Account

High-yield savings accounts pay interest that’s higher than traditional savings accounts. In fact, some high-yield savings accounts could earn as much as 10 times the national average.

Money Market Account

A money market account is an account offered by banks and credit unions. It combines elements of a checking account and savings account. For example, the account earns interest and you can write checks from it. In some cases, you might not be allowed to make more than six monthly withdrawals, and there may be minimum balance requirements.

Certificate of Deposit (CD)

A certificate of deposit (CD) is a savings account where you deposit your money for a fixed period of time. CDs are available in a variety of term lengths, from just a few months to five years or more. In exchange for leaving the CD for the entire term, the bank pays you interest on the money you deposited. Withdrawing money from your CD before its maturity date may result in penalties.

Compound Interest vs. Simple Interest

Compound Interest Simple Interest
Calculated based on the principal balance and interest earned Calculated solely based on the principal balance
Calculated daily, monthly, quarterly, or annually Calculated once annually
The formula is A=P(1+r/n)nt The formula is I = Prt

Generally speaking, there are two main types of interest an account can earn: simple and compound. Simple interest is calculated annually, and it’s solely based on your principal balance. In comparison, compound interest accrues based on the principal balance and any interest you’ve earned thus far.

The formula for calculating simple interest is:

I = Prt

I = Interest accumulated

P = Initial principal balance

r = Interest rate

t = Time periods elapsed (in years)

Frequently Asked Questions (FAQs)

What savings accounts have compound interest?

Many banks and credit unions offer savings accounts with compounding interest. The quickest way to know if an account offers compound interest is to look for “APY.”

What is a good APY rate?

A good APY on a savings account is one that exceeds the national average. You can find the national average rate for savings accounts on the Federal Deposit Insurance Corporations national rates and caps page.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. First Republic Bank. “Simple vs. Compound Interest: An Easy Guide.”

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