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The main benefit of compound interest to savers is the promise of exponential growth of their money. Once interest is added to an account, it starts earning interest itself, increasing the rate at which the account can grow. This applies to all sorts of savings instruments, including savings accounts, money market funds, and certificates of deposit (CDs). Lenders also benefit from compound interest because unpaid interest added to a loan's balance will also earn additional interest, increasing the amount of the balance due.
When a savings deposit is left untouched except for the addition of interest, each such addition will be larger than the previous one, and will eventually be larger than the amount of the original deposit. When combined with even a modest regular savings program, such an account can grow very quickly. This is what's meant when people refer to the "miracle of compound interest."
When money is loaned or deposited, that amount — called the principal — earns interest, which is basically the cost of using the money. Interest is "simple" if it isn't added to the principal amount and "compound" if it is. Calculated as a percentage of the principal, it is usually expressed as that percentage paid over a certain period of time.
For instance, a particular savings account may pay 5% annual interest, calculated and credited — or compounded — quarterly. When annual interest is compounded on a period of less than a year, it is pro-rated, so that the quarterly compounding of 5% annual interest would actually be 1.25% of the principal amount. The 1.25% earned in the first quarter is added to the principal amount and becomes part of the basis for calculating the second quarter's interest payment, and so on. Savings instruments of a year's duration or less, though, like many CDs, usually pay only simple interest, calculated once at maturity and paid to the owner with the principal.
Savings accounts and money market accounts, among others, generally compound interest more frequently than CDs. The frequency with which interest is compounded is an important consideration when comparing accounts. If two accounts have equal interest rates, the account for which compounding is more frequent will grow faster. Thus, an account with a 5% annual interest rate that is compounded quarterly will grow faster than one whose interest is compounded every 6 months. Some institutions, however, calculate interest very frequently, often daily, but credit the account less frequently, such as monthly or quarterly, thus dampening the compounding effect somewhat.
The method used to calculate interest can vary among institutions. A few institutions base the calculation on the lowest balance during the calculation period — that is, only that money that was in the account for the entire period. Another method is based on the average daily balance amount, while some institutions calculate interest on the actual daily balance. All depositors, but especially those who use their accounts frequently, benefit the most from daily calculation of interest. The average daily balance is the next most beneficial method, while the lowest daily balance is the least advantageous.
Compound interest is also a feature of loans. When money is loaned, the interest due is usually expressed as an annual rate payable monthly. If the interest due is paid on time, there is no compounding effect. If less than the full amount of interest due is paid, however, the unpaid amount will begin to accumulate interest itself at the beginning of the next period. This is a feature of revolving credit loans like home equity lines of credit (HELOCs) and credit cards that is of benefit to lenders.
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