The Magic of Compounding Interest: How It Can Supercharge Your Savings
When most people think of compounding interest, credit cards, mortgages, and personal loans come to mind. Unfortunately, these examples work to your disadvantage as they lead to higher interest charges you must pay. But there’s another side to compounding interest that works in your favor, and you can use it to supercharge your savings starting today.
What is Compounding Interest?
Compounding interest is interest that accrues on your loan principal – the original amount you financed – and then more interest is calculated based on the new loan principal each time interest compounds. The lender determines how this type of interest compounds daily, monthly, or annually.
The more frequently interest compounds, the more you’ll pay over the loan term. For this reason, it’s crucial to make loan and credit card payments on time, every time – to avoid paying unnecessary interest and late fees.
Compounding Interest vs. Simple Interest
There are two types of interest: simple and compounding. The difference is how they are calculated.
Simple interest uses a straightforward calculation; it takes the loan principal – the amount you borrowed – and multiplies it against the interest rate over the loan term.
- For example, a $10,000 loan with 7.5% simple interest over five years would cost you $3,750 in interest. Remember that this doesn’t reflect the cost of taxes or loan fees.
Compounding interest is trickier because the interest builds on any accumulated interest.
- Using the example above, assuming you make your loan payments on time each month, you’ll pay less interest over the loan term: $2,022.77. However, if you miss one or more payments, the interest you’ll pay quickly builds. Missing payments on more complex loans results in paying interest on your loan principal and any accrued interest. So, you end up paying more interest on the loan.
Best Ways to Maximize Savings Using Compounding Interest
While these are great examples of how compounding interest works with loans, we want to focus on how to turn that interest in your favor and maximize your savings.
It’s time to show you how your money can work harder for you instead of you working harder for money. There are four easy ways to accomplish this: savings account, money market account, certificate of deposit, or treasury bond.
1. Savings and Money Market Accounts
Savings and money market accounts work similarly. The difference between the two from an interest rate perspective is that money market accounts tend to earn a higher interest yield than regular savings accounts.
Earning compound interest on your savings is calculated based on the amount in your account. Interest generally compounds daily, and the yields are added to your account monthly. The more money you have in your account each month, the more interest you earn.
2. Certificates of Deposit
Certificates of deposit are fun when you really want to watch your money grow. They earn significantly more interest than savings and money market accounts. Make no mistake; having a savings account is essential. But adding one or more CDs will supercharge your savings faster and help you build wealth.
Remember that interest rates fluctuate, so today’s rates might change tomorrow or next week. We sometimes offer special promotional rates for CDs, too. So, watch for those and take advantage of them.
3. Treasury Bonds
Unlike savings accounts, money market accounts, and CDs, treasury bonds are a type of investment. But they do earn compound interest, which gives you a higher overall return on your investment.
Treasury bonds are a long-term investment, meaning they earn interest as they mature, which usually takes 10 years or more depending on the bond. However, unlike other investments such as stocks and mutual funds, treasury bonds are one of the safest investments available because you’ll have the full faith and credit of the U.S. government backing them.
The Final Word
You can use compounding interest to grow your wealth with the different savings vehicles mentioned above. You’ll earn more money over time by reinvesting the accrued interest into your savings.
Whether your goal is to build your net worth or save for retirement, compounding interest is a powerful tool to supercharge your savings, allowing your money to work harder for you.