Earning compound interest is the best way to make your savings grow faster, since you’re earning interest on the principal and the interest you’ve already accumulated. If you want to determine how much your money will increase due to compound interest, try our free compound interest calculator.
Understanding how compound interest works will help you make better financial decisions, but the financial terminology can be confusing for some people. Here are some essential terms you need to understand when using the compound interest calculator:
The investment amount is the money you initially invested. It’s also sometimes called the principal.
The interest rate is the interest you’ll earn on your investment. The bank determines the interest rate, though it’s loosely tied to the federal funds rate.
This refers to the number of years you plan to invest your money.
This is the interest you earn on the original investment and any interest you accumulated.
The yearly APY is the annual percentage yield you’ll receive if the interest is compounded annually.
The quarterly APY is the annual percentage yield you’ll receive if the interest is compounded quarterly.
The monthly APY is the annual percentage yield you’ll receive if the interest is compounded monthly.
This is the annual percentage yield you’ll receive if the interest is compounded daily.
Compound interest means you earn interest on the original amount you invested and any interest accumulated. Because you’re earning interest on your interest, your savings will grow faster over time. [Read related article: Financial Tracking 101: Best Implementation Practices and Best Tools]
If you open a savings account that earns simple interest, you’ll earn interest only on the principal. Because compound interest includes any interest accumulated, your investment returns will be higher over the long run.
And the more frequently your interest compounds, the more interest you’ll earn. The compounding period is how often your interest is added to the account. Interest can be compounded annually, semiannually, quarterly, monthly or daily.
For example, let’s say you invested $1,000 in a savings account earning 5% interest that compounds annually. The first year, you’ll earn $1,050, and after five years, you’ll have $1,276.28. If the interest is compounded semiannually, you’ll have $1,280.08 after five years. And if it is compounded quarterly, you’ll earn $1,282.04 over that period.