How Does Daily Compounding Work?
If you plan to put money in a savings account, it’s natural to try to find a bank that offers you the highest possible return on your money. You may take time to shop for the best interest rates while also exploring which banks have the lowest fees.
In recent years, savers have benefitted from the growth of online banks competing with offers of above-average interest rates and low costs.
Many banks have also been trying to lure deposits by the way they calculate total interest returns. Specifically, some banks will compound interest daily, rather than monthly or quarterly, which can lead to additional income for the account holder.
But how much more can you earn through daily compounding? Does it make enough of a difference to be a deciding factor when selecting a bank? Let's compare it to less frequent compounding and see how it holds up.
How Does Compound Interest Work?
Compound interest can be a powerful tool for helping you achieve your financial goals. The basic idea is that as you earn interest, you're not only earning interest on the original sum of money you deposited, you're also earning interest on the previous interest you earned.
For example, if you start with $100 and earn 1% annually in interest, you end up with $101. The next time interest is calculated, you will earn 1% of $101, giving you a total of $102.01. The next time, you'll earn interest on that amount, and so on.
To calculate compound interest, use the following formula:
A = P(1 + r/n)nt
Here is how the formula breaks down:
- A = the future total value
- P = the initial deposit
- r = the annual interest rate
- n = the number of times that interest is compounded per year
- t = the number of years the money is saved
Over time, compound interest can help generate additional income. The more you are able to deposit, the more you’ll earn long term as your deposits and interest accumulate.
Let's take a look at an example to see how much money you can earn on a daily vs. monthly compounding schedule.
Comparing Monthly and Daily Compound Interest
Let’s assume that you’ve opened an online savings account and deposited $10,000. Your goal is to leave that money alone for five full years and let it grow. And let’s also assume that this bank pays an interest rate of 2%, with interest compounding on a monthly basis. How much money will you have five years from now?
To determine the first interest payment, you begin with $10,000 and multiply it by 0.02. That comes to $20. You add the $20 to your total so that the following month you multiply $10,020 by .02. Over the course of five years, you’ll get 60 interest payments.
Using a compound interest calculator, you can determine that you’ll generate $1,050.79 overall, totaling $11,050.79 at the end of five years.
But what if a bank claims it will compound interest daily? In this case, we make the same calculations 365 times per year instead of 12.
Our calculator shows that you’ll earn $1,051.68 over the course of five years, giving you a total of $11,051.68.
How much difference did daily compounding make? Your additional savings came to $0.89 in five years. Obviously, this isn't a significant amount. In fact, it wouldn't even outpace inflation.
Even if you put $250,000 into a savings account (the maximum protected by the FDIC), you will end up with about $20 extra in your pocket after five years. Perhaps you could buy yourself lunch, but not much else.
The Bottom Line
Daily compounding of interest from your savings account might net you a few cents, but not much more. If a bank offers you daily compound interest, you shouldn't turn down the free money. But keep in mind that daily compounding makes only a minimal difference in how much you can ultimately save.
As a consumer, you should understand that daily compounding matters far less than the interest rate being paid and any fees you may incur. So don’t overlook other bank account features in favor of daily compounding interest.