Should Daily Compounding Matter When You Pick a Bank?
It Might Net You a Few Cents, but Not Much More.
If you intend to put money in a savings account, it’s natural to try and 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 fewest fees.
In recent years, savers have benefitted from the growth of online banks that have been 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 on a daily basis, rather than monthly or quarterly, and this can lead to additional income for the account holder. Online banks offering daily compounding include Ally Bank, PurePoint Financial, and Marcus by Goldman Sachs.
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? Our analysis suggests that you’ll earn a very small amount of additional passive income, and that it should not be a crucial differentiator when deciding on what bank to choose.
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 are not only earning interest on your original sum of money, but you earn interest on the previous interest payments. For example, if you start with $100 and earn 1% 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 formula for calculating compound interest is: A = P (1 + r/n)nt.
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. So it stands to reason that the more you are able to deposit, the more you’ll earn longterm. Let's take a look at an example to see how much money you can earn.
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’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 $200. You add the $200 to your total, so that the following month you multiply $10,200 by .02. Over the course of five years, you’ll get 60 interest payments.
Using a compound interest calculator (we will use this one from Moneychimp, but there are many others available online for free), 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 89 cents in five years. Obviously, this is not a significant savings. In fact, it would not even help outpace inflation.
Even if you put $250,000 into a savings account (the maximum protected by FDIC insurance), you will end up with about $12 extra dollars in your pocket. 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 should not 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.