Compound interest savings accounts

So, what is a compound interest account? A compound interest savings account is any savings account that allows you to earn interest on both the principal balance and the previously accrued interest.

Savings accounts will offer either simple interest or compound interest, so in this way, a compound interest savings account isn’t a type of savings account in itself. Instead, it’s a feature that a number of savings account types, including CD Accounts and money market accounts, can offer.

When it comes to savings accounts, compound interest means you earn interest from both your principal (your original deposit) and any already-accrued interest, allowing you to earn interest on interest. Savings accounts that compound interest create a snowball effect, as the longer you keep your money in the account, the faster the money grows. On top of this, the more frequently interest is compounded (for example, daily rather than monthly), the more you’ll earn as time goes on.

While compound interest can help your savings grow, it’s also used in many types of loans, such as credit cards and mortgages, where it can increase how much you owe over time if you’re not careful.

Let’s look at how a compound interest savings account works in practice.

Let’s say you make a $2,000 investment and receive a 6% rate of return. In your first year, you’ll only earn simple interest, as the interest hasn’t compounded yet. However, by the second year, you’ll earn another 6% return on your new balance. This means your principal of $2,000 would look like this:

Year 1: $2,000 x 1.06 = $2,120

Year 2: $2,120 x 1.06 = $2,247

In two years, you will have gained almost $250 — $7 of which is compound interest— simply by keeping it invested. This might not seem like a lot, but compound interest can have a significant impact in the long term. You can read more in our guide to how interest works on savings accounts.

What is the Rule of 72?

The above is a simple calculation that you can use to give you a quick estimate of interest over a few years. However, the ‘Rule of 72’ allows you to look even further ahead by estimating the number of years it would take to double your money at a specific rate of return in a compound investment account.

The formula looks like this: Years to double = 72 / interest rate

To use the example of the investment above (a $2,000 investment and a 6% return), we’d calculate 72 ÷ 6 = 12. So, in this example, the original deposit would take around 12 years to be doubled.

Generally, the more frequently the account compounds, the better, as your interest is earning interest more often. You may find compound interest bank accounts that offer annual, semi-annual, quarterly, monthly, or daily compounding.

However, it’s worth considering other features when researching compound interest savings accounts — for example, the difference between monthly and daily compounding may be minimal for short-term investments. Some types of compound interest accounts may also offer lower compounding frequencies, but higher nominal interest rates — that is, the base rate before compounding is taken into account.

APY, short for Annual Percentage Yield, shows you the real rate of return on your money in one year, taking into account the effect of compounding interest. Knowing the APY makes it easier to compare two different savings accounts, as even if they have different nominal interest rates, the one that compounds more frequently will have a higher APY.

In terms of what types of accounts have compound interest, there are many savings accounts that offer this as a feature. These include:

Traditional savings accounts

A traditional savings account is used to grow your savings without sacrificing access to funds. Savings accounts typically offer higher interest rates than checking accounts, which tend to be used primarily for daily expenses through payment methods like debit cards and checks.

Money market accounts (MMAs)

Money market accounts provide the conveniences of a regular savings account, but with a significant added benefit — they often offer higher interest rates than traditional savings or checking accounts. However, some financial institutions may limit how frequently you can withdraw funds from this type of account or impose high minimum deposit requirements.

Certificates of deposit (CDs)

Certificates of deposit, also known as CDs, are a type of deposit account offered by banks and credit unions that allow you to earn interest on your money. CDs typically offer some of the highest available interest rates of all banking deposit products. You’ll usually deposit a set amount of money, and then you won’t be able to access this for a set period, from as little as three months to as long as five years.

High-yield savings account (HYSA)

High-yield savings accounts typically offer more flexibility, allowing you to deposit and withdraw money. They usually have higher rates than regular savings accounts, however, you might also need to maintain a minimum balance in order to receive the advertised interest rate.

So, what is a good compound interest account? The answer will depend on several factors, including your financial goals, timeline, appetite for risk, and access requirements.

As a general rule, before opening a compound interest account, it’s a good idea to consider:

• Savings goals: Are you saving money for an emergency fund, a short-term goal like a vacation or a house, or long-term growth? Do you need access to your money, or are you happy to lock it away for a set period?
• Interest rates and fees: Look for a high APY, as well as accounts with no or low fees
• Compounding frequency: More frequent compounding means you’ll earn more money. Consider accounts that compound daily or weekly rather than monthly or annually.
• Security: Always ensure any savings account you open is protected by the Federal Deposit Insurance Corporation (FDIC) if it’s a bank, or the National Credit Union Administration (NCUA) if it’s a credit union, so your money is protected up to the stated limit.

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