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Discrete compounding is a means of calculating the interest that is earned on deposits. The process of discrete compounding is utilized at specific finite periods of time, such as daily, monthly, or annually. This method of compounding interest makes it possible to systematically add the calculated interest to the current principal in the account, plus any interest that has accrued on the principal.
Discrete compounding is slightly different from continuous compounding. While both methods are used to compound the interest that is applied to the customer account, continuous compounding adds in interest accrued at infinitely shorter intervals than is used with discrete compounding. Depending on the frequency of deposits made into the account, one method may be preferable to the other.
By rolling the accrued interest into the account at regular time intervals, discrete compounding makes it possible for the account holder to time deposits so they will have a positive effect on the amount of interest that is earned on the activity. At the same time, the account holder can make it a point to issue payments or withdraw funds from the account in such a manner as to earn the maximum amount of interest possible, while still making use of the funds in the account.
Financial institutions may use discrete compounding to calculate interest due on interest bearing accounts, or use the continuous compounding method. Both approaches are considered to be workable and will result in interest earned, assuming that the account holder does maintain any minimum balance required by the institution. In some cases, banks may base the usage of discrete compounding over continuous compounding on such factors as the type of account, the minimum balance necessary to earn interest on the account, and the anticipated amount of withdrawal activity associated with the account.
When deciding on which bank to use for interest bearing accounts, it is always a good idea to have a clear understanding of how the bank will apply interest to both the balance and the deposits. Doing so allows the customer to choose a bank that will yield the most interest applied to the account, given the frequency of deposits that the customer makes on a regular basis.