Q:

How does compound interest on a savings account work?

A:

Quick Answer

Compound interest in a savings account accelerates interest earnings by paying interest on the portion of the account balance made up of previously earned interest. Interest in a savings account accrues at a rate that varies among banks and may compound daily or monthly.

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Full Answer

The interest rates for a savings account is the annual percentage rate paid on the principal account balance. For example, an APR of 5 percent on a balance of $1,000 would result in a simple interest amount of $50, or 5 percent of $1,000, at the end of the year.

If the interest on the account compounds monthly, then after each month's interest payment, the new balance including interest becomes the principal balance. For example, an APR of 5 percent on a balance of $1,000 would result in an interest amount of one-twelfth the annual interest being added to the principal balance. Since 5 percent of $1,000 divided by 12 is $4.17, the new principal balance would be $1,004.17.

The next month adds monthly interest in the amount of one-twelfth of 5 percent of $1,004.17, which is $4.18. Compound interest causes the principal balance of an interest-bearing account to grow, resulting in increasing interest earnings. Left untouched, compounding returns add up faster as time goes by. Shorter compounding periods allow interest to compound more quickly. The annual percentage yield on an account, or APY, is the rate including compounding returns.

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