If you save your money in interest bearing accounts you know the beauty of compounding interest. It can be one of the most powerful tools in your investment toolbox. This type of interest earns helps your money grow faster because of the way the interest is added to your balance. There are different types of compound interest, which means there are more ways to make your account grow larger.
Function
Compound interest adds the interest gained over a period of time, to the original principal then it counts that new principal when it calculates the next amount of interest to be earned. So, each period of interest is added right bank into the total amount of money the interest is to be earned on. That means you earn more and more interest each time the interest is calculated.
Types
There are several types of compound interest that refers directly to the time period in which the interest compounds. These include daily, monthly and yearly compound interest. In daily compounding interest, the interest is added to the account every day, and the rate applied to this new principal. In monthly compounding interest, the rate is applied every month, and so on.
Features
Compound interest has what is called a periodic rate, or the rate that is applied to the balance, a compounding period, which the length of time before that interest is applied to your balance. So, if you invest $1,000 in a .1% periodic rate money market account which compounds daily, after the first day your balance will be $1,001. The following day the .1% periodic rate would be applied to the balance of $1,001, and so on throughout the year. The annual effective rate would be the total interest earned versus the original balance over the course of the entire year.
Significance
Compound interest can be a very powerful tool because your interest is added right back into your account balance as principal and the next period, the interest rate is applied to a higher balance. It means accounts can grow faster and interest is not withheld. The effect of compound interest is only multiplied by tax-deferred accounts, like annuities and some municipal bond funds. Without paying a tax penalty every year, your money will grow faster much faster because you have more in your account, which earns you more interest. Each and every year, the amount of interest you earn increases, and is added to your account without penalty.
Considerations
Compounding interest can have an extreme effect on how large your account grows after several years. For instance, $10,000 invested into an account paying 12 percent interest at a periodic rate will grow to only $46,000 in 30 years if the interest is not compounded. It will grow to $299,599.22, when that interest is compounded back into the principal every year, and $347,109.87, if the interest is added back into the balance every quarter. Choosing a higher periodic rate interest rate with a daily, or monthly compounding interest period will earn the most money over the course of time.
