However, while CDs generally have fixed interest rates, savings accounts tend to have variable rates that can change daily due to market fluctuations. Though the above example is a nonspecific representation of compound interest in action, the truth is that compounding can come in different forms and be calculated in different ways.įinancial instruments such as certificates of deposit (CDs) or high-yield savings accounts also have compounding interest. Interest Rates in Savings and Investments If the return were calculated using simple interest instead, the total amount would be $62,500, or about 72% less than with compounding interest. The magic of compounding interest turned $25,000 into $108,048.56. The total interest accrued for the whole 30 years is a whopping $83,048.56. Total with compound interest at end of interval Let’s compare two scenarios with an initial principal of $1,000, both with a 5% interest rate that is calculated yearly, but one has simple interest while the other has compound interest.Ĭompound interest accrued during five-year period Therefore, if both simple and compound interests have the same rate, the interest generated will always be higher when compounding.īoth types of interest are calculated at certain periods which can be annually, semiannually, quarterly, monthly, daily, or any other period defined by the financial institution. Simple interest is the interest generated only from the principal. The difference? Compound interest includes the interest generated on the principal and the accumulated interest from any previous period. It can be found in amortized loans such as car loans, student loans, and mortgages, or short-term personal loans. Simple interest is, as its name implies, easier to understand. The Difference Between Simple Interest and Compound InterestĬompound interest can be found in savings accounts, certificates of deposit, investment instruments, loans, and credit cards. įor more money activities for your child, visit our Money As You Grow section.Hawaii Alaska Florida South Carolina Georgia Alabama North Carolina Tennessee RI Rhode Island CT Connecticut MA Massachusetts Maine NH New Hampshire VT Vermont New York NJ New Jersey DE Delaware MD Maryland West Virginia Ohio Michigan Arizona Nevada Utah Colorado New Mexico South Dakota Iowa Indiana Illinois Minnesota Wisconsin Missouri Louisiana Virginia DC Washington DC Idaho California North Dakota Washington Oregon Montana Wyoming Nebraska Kansas Oklahoma Pennsylvania Kentucky Mississippi Arkansas Texas GET STARTED You can also crunch some numbers using different rates, periods of time, and compounding frequencies, at the Securities and Exchange Commission’s website. For example, if you had $1,000 that was earning a 6 percent return, it would grow to $2,000 in 12 years (72 divided by 6 equals 12). It uses the rule of 72, which basically says if you divide 72 by your rate of return, you’ll find out how fast your money will double in value. It’s for a slightly older audience – probably college students – but it illustrates compounding in way that most pre-teens and teens would understand. You can also watch this video by the Financial Literacy Center, a joint center of the RAND Corporation, Dartmouth College and the Wharton School. That could help boost your child’s “interest.” But if you want to encourage your child to save, consider adding a matching contribution – say, 25 cents for every $1 saved. TIP: It’s hard to find accounts or real-world investments that pay a steady 5 percent or 10 percent return. Then run through a simulation like the one above, calculating the next interest payment on the principal-and-interest total each time. You can teach compounding using your own change jar and there are lots of good resources on the web.įor the low-tech method, dump your change jar out on the floor and tell your children they will invest $1 at 10 percent interest. Increasing the compounding frequency or your interest rate, or adding to your principal, can all help your savings grow even faster. That’s because the next interest payment equals 5 percent of $1,050, or $52.50. The second year, you would have $1,102.50. After the first year, you would have $1,050 – your original principal, plus 5 percent or $50. So let’s say you invest $1,000 (your principal) and it earns 5 percent (interest rate or earnings) once a year (the compounding frequency).
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