Learn how interest works

You are paid interest when you make your money available to a bank, who then lends to borrowers. When you look at different savings options, you need to understand how interest works.

• Simple interest is what you earn over time on the principal alone. For example, you deposit $1,000 and earn a simple rate of 5 percent each year for five years. Here is what your earnings look like:
  • Year 1: $50 earned, balance is $1,050
  • Year 2: $50 earned, balance is $1,100
  • Year 3: $50 earned, balance is $1,150
  • Year 4: $50 earned, balance is $1,200
  • Year 5: $50 earned, balance is $1,250
• Compound interest is the amount earned on the principal plus any prior interest earnings. The more frequently interest is calculated (or compounded), the faster and bigger your balance grows. Using the same $1,000 deposit and 5 percent return as the prior example, with interest compounding yearly, your earnings look like this:
  • Year 1: $50 earned, balance is $1,050
  • Year 2: $52.50 earned, balance is $1,102.50
  • Year 3: $55.12 earned, balance is $1,157.62
  • Year 4: $57.89 earned, balance is $1,215.51
  • Year 5: $60.77 earned, balance is $1,276.28
• Annual percentage yield (APY) is the actual amount paid when compounded interest is accounted. In the example above where the quoted return is 5 percent, the APY is actually higher, at 5.10 percent.

Compounding interest, or earning interest on interest, is said to be one of the most powerful financial tools you can put to work for you. Even small deposits add up over your lifetime, and your balances continue growing bigger the longer you save.

See for yourself how compound interest works using the Compound Interest Calculator Links to an external site. offered by the U.S. Securities and Exchange Commission.

 

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