Understanding Compound Interest Can Improve Your Savings

Consistently saving money is perhaps the most powerful financial habit you can adopt. It can be the difference between living paycheck to paycheck or working toward your long-term goals so you can achieve the future you want. But what if you could grow your money without having to do anything at all, just by virtue of having invested it in a specific type of account?

That's where interest comes in. It makes the money you put into your accounts grow over time. How much growth you see depends partly on the type of interest you have—specifically, whether or not it's compound interest.

The basics

When you put money in an interest-bearing account, you'll get an annual percentage yield, or APY. This is what you can expect to earn on your savings in one year. Some certificates of deposit and other types of accounts use this type of interest.

Calculating interest is relatively straightforward. Let's say, for example, you put $1,000 into your account, and the APY is 1%. At the end of one year, if you haven't taken anything out of your savings or added any deposits, you'll have $1,010. For year 2, you'll earn 1% interest on $1,010.

How compound interest works

Compound interest takes this a step further. Instead of being calculated every year, this type of interest compounds much more frequently—in most cases, every month. 

Perhaps the easiest way to understand this concept is to think of it as interest on interest. Compound interest is calculated based on the principal—the original amount of the investment—as well as all your additional deposits and the interest you've already earned to date. This can help your money grow much more quickly.

Compound interest is most common with investments, including retirement accounts and mutual funds. You'll also earn compound interest on most savings accounts, though the rates are typically much lower. It's one of the reasons why utilizing compound interest when you're younger can pay off over the long term.

Here's an example. Let's say you start with an initial deposit of $1,000, with an estimated interest rate of 7%. You add $100 a month to this account. In one year, the projected future value of your savings, barring significant market fluctuations, is expected to be $2,270.

Where compound interest really helps your money grow is over time. If you put your $1,000 into your account with an estimated interest rate of 7% and held it there for 5 years, still contributing $100 a month, the value is over $8,300.

That highlights some of the power of compound interest. With patience, investing over the long term has the potential to increase the value of your savings significantly.

How to start taking advantage of compound interest

One of the most important ways you can capitalize on compound interest is to start saving early. The difference between starting at 25 compared to 45 can be significant, but it's never too late to start—with compound interest, every day matters.

Look at your company's retirement savings programs, such as a 401(k), as a place to start. You can also open up your own individual retirement account, or IRA. Many banks offer money market accounts and certificates of deposit to customers, which also use compound interest.

Now that you understand compound interest and how it works, you can consider your options and figure out the best approach to help grow your savings. Wherever possible, invest in accounts that carry compound interest, and shop around for the best interest rates that you can find on savings and other types of accounts. Combined with a strong saving habit, the know-how to take advantage of compound interest can be one of your best assets as you work toward your financial goals.