How compound interest can supercharge your savings

Whether you’re saving for the down payment on a vacation home or to pay for your children’s college tuition (one day), compound interest can help your savings move closer toward your goals.

Compound interest is a mathematical concept that essentially allows your money to multiply and accumulate at a specified rate over time. Compounding means that you earn new returns on the gains you’ve previously made, potentially allowing you to reach your financial goals quicker.

Compound interest can help a bit with short-term goals, like building or supplementing an emergency savings account, or extra padding for a bucket-list vacation. However, over time the “magic” really kicks in, as the gains increase with the longevity of the account. Therefore, compound interest is a great strategy for the funds earmarked for retirement, a child’s college tuition, or a home downpayment.

Here is a hypothetical example just to illustrate the math.

Let's say you deposit $1,000 in an account (that's your principal). If the account earns 10% interest, you've earned $100 after a year.

So far, so good. Now watch what happens the following year:

You've earned more in year two ($110 more, to be exact) without depositing any more money from your pocket! So, what makes compound interest so great? Look what happens if you let your savings ride for 10 or 20 years.

As shown, the key to compound interest is time, or giving your money time to grow. That’s because the amount that you earn in compound interest gets bigger (and bigger!) each year you let your money accumulate. Also, the more money you put into a compound interest paying account, the more you’ll earn.

Going back to our example again, note the difference in compounding for 10 years versus 30 years.

One more (interest)ing point: while you can get the benefits of compound interest in interest-bearing checking, saving, and investment accounts, there are important differences to understand:

• Checking: You can actually earn compound interest on some interest-bearing checking accounts. The interest compounds daily; therefore, your return may increase or decline if your account balance increases or decreases (although you won’t lose interest you’ve already earned).
• Saving: You won’t lose your principal in a traditional savings account, but when interest rates fall your returns may fall as well.

For example, a $1,000 deposit, with no monthly contributions, compounded annually at a 4.5% APY will yield you a $45 gain after the first year. If the rate falls to 3.5% in the second year, your $1,045 balance, with no additional contributions, will result in a $36.58 gain—a little less than the interest from the first year.

Different types of savings products work in different ways. For example, you may be able to get a higher interest rate on a certificate of deposit (CD) than on a savings account, but, in return, you may have to leave your money in that CD for a specified term. That said, if you don’t need the money right away, a CD can be a wonderful way to lock in compound savings for a portion of your nest egg.

• Investing: If you have an investment account, you can also enjoy the benefits of compound returns—and they’re key to making up for the higher volatility that comes with investing in the market. Unlike with checking or savings accounts, returns on your investments can be both positive (when the value of your stocks goes up) and negative (when stock values go down). In general, however, the long-term returns of diversified stock investments have historically been higher than the amount of interest you’d earn in savings.

How compound interest can help you meet your goals

One more thing to keep in mind: The example above did not include fees or taxes that would likely apply in a real account. So, keep that in mind when deciding how and where to invest your money. Happy Saving!