What are the benefits of compound interest?

The main benefit of compound interest for savers is the promise of exponential growth in their money. Once interest is added to an account, it starts earning interest, which increases the rate at which the account can grow. This applies to all types of savings instruments, including savings accounts, money market funds and certificates of deposit (CDs). Lenders also benefit from compound interest because unpaid interest added to the loan balance will also earn additional interest, increasing the amount of the balance owed.

When a savings deposit is left untouched, except for the accrual of interest, each accrual will be greater than the previous one and, eventually, will be greater than the value of the original deposit. When combined with a regular modest savings program, this account can grow very quickly. This is what is meant when people refer to the "miracle of compound interest".

When money is borrowed or deposited, this amount, called the principal, earns interest, which is basically the cost of using the money. Interest is "simple" if it is not added to the principal amount and "compounded" if it is. Calculated as a percentage of principal, it is usually expressed as the percentage paid over a given period of time.

For example, a particular savings account may pay 5% annual interest, calculated and credited, or compounded, quarterly. When annual interest is compounded for a period of less than one year, it is prorated so that the quarterly compounding of 5% annual interest is actually 1.25% of the principal amount. The 1.25% earned in the first quarter is added to the principal amount and becomes the basis for calculating interest payments for the second quarter, and so on. However, savings instruments with a duration of one year or less, such as many CDs, generally pay only simple interest, calculated once at maturity and paid to the owner with principal.

Savings accounts and money market accounts, among others, generally earn interest more often than CDs. How often interest is compounded is an important consideration when comparing accounts. If two accounts have equal interest rates, the account for which compounding is more frequent will grow faster. Therefore, an account with a 5% annual interest rate compounded quarterly will grow faster than an account with compound interest every 6 months. However, some institutions calculate interest very frequently, often daily, but credit the account less frequently, such as monthly or quarterly, which dampens the compounding effect somewhat.

The method used to calculate interest may vary between institutions. Some institutions base the calculation on the smallest balance during the calculation period, that is, only that money that remained in the account during the entire period. Another method is based on the average value of the daily balance, while some institutions calculate interest on the actual daily balance. All depositors, but especially those who use their accounts frequently, benefit most from the daily calculation of interest. The average daily balance is the next most beneficial method, while the lowest daily balance is the least beneficial.

Compound interest is also a feature of loans. When money is borrowed, interest due is usually expressed as an annual fee payable monthly. If the interest due is paid on time, there is no compounding effect. However, if less than the total amount of interest due is paid, the unpaid amount will begin to accrue interest at the beginning of the next period. This is a feature of revolving credit loans such as home equity lines of credit (HELOCs) and credit cards that are beneficial to lenders.

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