April 19, 2024
Don’t Miss Out on Compound Interest. Here's How to Double Your Savings Without Lifting a Finger

Compound interest is bad news when you have high-interest credit card debt, but it’s good news when you have extra cash. If you have the right savings account, compound interest lets you earn interest on top of interest, helping to accelerate the growth of your savings. 

That’s why Albert Einstein famously referred to compound interest as “the eighth wonder of the world.” To paraphrase: Anyone who understands compound interest, earns it. Anyone who doesn’t understand compound interest, pays it.

The Federal Reserve’s ongoing battle to tame inflation has kept interest rates high. That means you could find yourself further in the red if you’re borrowing money with a high-interest loan or relying on your credit card with a steep APR. But if you want your cash to grow faster than usual, you can use a high-interest savings account to leverage the power of compound interest. 

Late last year, I opened a top-yielding savings account, deposited $1,000 and set up regular automated transfers from my checking account. When I did the math, I saw that my savings would double in just one year. Compound interest really is magic. 

What is compound interest?

Compound interest is a powerful and simple way to have the value of your savings increase, but you’ll need the right savings account, money market account or investment tool, like a certificate of deposit.

When you put money into an account that earns compound interest, you aren’t just earning interest on your initial deposit amount (known as the principal). Your interest also earns interest, therefore growing your account balance. In contrast, simple interest applies to the principal only.

For example, if you deposit $1,000 in a high-yield account that earns a 5% annual percentage yield and compounds interest daily, you’d end up with a balance of about $1,051 in one year without making any additional contributions. Assuming that the same 5% APY is applied to your new balance, you’d end up with $1,105 after the second year. 

The higher the balance in an account, the more you’ll earn in interest. Say you deposit $10,000 into that same high-yield account with a 5% APY compounding daily. You’ll have roughly $10,513 after the end of one year. That breaks down to almost $43 extra cash each month toward your savings goal.

According to S&P’s Global Financial Literacy survey, people who don’t understand the concept of compound interest tend to borrow more and save less while running up bigger debts and getting higher interest rates on loans. When we understand compound interest, we can make better decisions about where to put our money. 

Read more: How Savings Interest Works

Why go with a high-yield savings account?

Stashing money in a high-yield savings account is a low-risk way to take advantage of compound interest and maximize the growth potential of your returns. The top high-yield savings accounts currently earn APYs as high as 5.35%, more than 10 times the national average of savings account rates at 0.47%. 

In December, I opened a high-yield savings account with Ally that earns 4.35% APY. Compare that to my previous savings account at my local credit union, which earned a paltry 0.01% APY. As a general rule, online-only banks consistently offer better APYs on savings accounts because they have fewer overhead costs than banks with physical branches.

Here’s what the interest looks like for each account after one year based solely on an initial deposit of $1,000:

Traditional savings account Ally high-yield savings account
APY 0.01% 4.35%
Initial deposit $1,000 $1,000
Compound frequency  Daily  Daily 
Balance after 1 year $1,000.01 $1,044.46
Interest earned $0.10 $44.46

That’s an extra $44 just for parking my savings in a higher-yield account. Keep in mind, however, that savings accounts earn a variable interest rate, meaning the APY can change anytime. Though accounts with variable interest rates can be unpredictable, interest rates for top-yielding savings accounts are expected to stay high for a while.

Pro Tip: Use a compound interest calculator

To calculate how much your money can grow with compound interest, use US Securities and Exchange Commission’s compound interest calculator. Enter in the amount of your initial investment, your monthly contribution (if any), the amount of time you plan to save, the interest rate and the compound frequency.

How I plan to double my savings in one year

I’m pretty vocal about my journey of paying off student loan debt and learning new ways to save while juggling debt. It’s all about finding the right balance for your financial situation. 

Small strides are still strides in the right direction. You don’t need to set aside $100,000 to make noticeable gains with your savings. 

After depositing $1,000 of savings into a HYSA with Ally last year, I’ll be able to double that figure in one year without making huge sacrifices or even budgeting much. Here’s how I’m doing it and how you can too. 

1. Deposit $1,000 (or any amount) into a high-yield savings account

Start by depositing $1,000 or a suitable amount in a high-yield savings account that earns 4% to 5% APY. Ally’s high-yield savings account currently earns 4.35% APY, but you can find savings accounts with rates as high as 5.35% APY. Make sure your initial deposit is a comfortable figure that you can put aside for at least a year without needing to withdraw it for daily expenses. 

2. Set up automatic transfers of $25 per week

Set up automatic recurring transfers to move money into your savings account on a weekly, monthly or quarterly schedule that works for your finances. Automating your contributions is a way to “set it and forget it.” You won’t ever have to manually deposit funds into your account, and your savings will still grow consistently. 

In my case, I set up a recurring automatic transfer of $100 from my checking account into my Ally savings account every month, which breaks down to $25 a week. It’s a reasonable amount based on my income, debt and expenses, but the exact amount you set aside will depend on your budget. 

3. Watch your balance double

Assuming the APY on my account stays around the same throughout the year, I’ll watch my balance more than double due to a combination of those monthly transfers and compound interest. Since interest rates are variable and could change once the Fed initiates rate cuts, I’ll reassess my contributions and adjust my projections when the time comes. Lucky for me, savings rates are expected to stay elevated for a while.

Initial deposit $1,000
APY 4.35%
Automated contribution amount $100
Contribution frequency  Monthly 
Compound interest frequency  Daily
Balance after 1 year $2,270.87
Interest earned  $70.87

After one year, my $1,000 will turn into around $2,271. Not too shabby.

What’s the difference between interest compounding daily vs. monthly?

How frequently your interest compounds determines how quickly your principal balance grows. Banks and credit unions can compound interest annually, monthly or daily. Most high-yield savings accounts compound interest daily and pay it out monthly.

While interest compounded daily can get you greater returns than interest compounded monthly or annually, the difference isn’t substantial. For your savings to grow, the more important factors are the APY and the length of time you save.

Let’s look at how interest compounded daily versus monthly can affect your savings:

Daily compounding Monthly compounding
APY 5% 5%
Initial deposit $1,000 $1,000
Contribution amount $100 $100
Contribution frequency Monthly Monthly
Balance after 1 year $2,281.69 $2,279.05
Balance after 2 years $3,629.08 $3,623.53
Balance after 5 years $8,100.09 $8,083.97

Is there a downside to earning compound interest? 

When compound interest applies to your savings earnings, you’ll be able to get more value over time, though you’ll always have to factor in APY and the length of time you invest. If the APY on your account is far below 1%, compound interest will likely amount to a few extra pennies. 

Keep in mind that any interest you earn from a savings account is considered taxable income by the IRS. When tax season rolls around, you’ll have to include the interest you earned for the filing year on your federal tax return. 

If you want to boost your wealth significantly, this savings strategy might be too “G-rated” for you. Investing your money in the stock market could get you greater returns in the long term, but you’ll have to evaluate your risk tolerance. 

The bottom line

Though high interest rates mean it’s not a great time to be a borrower, it’s a good time to be a saver. Take advantage of the power of compound interest while APYs on savings accounts are high. The sooner you do, the more interest you’ll earn.


Einstein was right.

Source link

Leave a Reply

Your email address will not be published. Required fields are marked *