3 Questions About Compound Interest — Answered

Compound interest is an incredibly powerful force. It allows your money to start growing on its own, with the returns exploding in value over time, if you have the patience.

While the idea is easy to understand, the actual application of it can be tricky. Does it make a difference if money is compounded monthly or quarterly? How does one teach the idea to young children? Are there any places that offer steady compound interest with a high interest rate? Let’s dig in!

In this article

    Impact of bank compounding quarterly

    Angie writes:

    I used to keep my savings at one bank but I didn’t like their service so I switched everything to a new bank. The new bank is great except that they only put interest in my checking account quarterly. The APR on both accounts is the same. I’m trying to figure out how much I’m losing and if it is worth it to find another bank.

    It’s probably not worth it to find another bank if you like the customer service at your current bank.

    Let’s say you have a large amount in savings — $100,000. Let’s also say that the bank offers 0.5 percent APR on their savings account, which is a reasonable amount in the current banking world. I’m guessing that your old bank compounded monthly, as that’s very common in banking, and your new bank compounds quarterly.

    At your old bank, with monthly compounding, you would earn $501.15 in interest in a year. At your new bank, with quarterly compounding, you would earn $500.94 in interest in a year. That’s right, over the course of a year, with $100,000 in the account at 0.5 percent APR, the difference between the two is about 20 cents.

    With interest rates as low as they are, different compounding rates don’t make a huge difference. However, if interest rates rebound strongly, you may want to pay attention. Let’s say that interest rates were 5 percent instead of 0.5 percent. In that case, the monthly compounded account would generate $5,116.19 in interest, whereas the quarterly compounded account would generate $5,094.53 in interest. Suddenly, you’re talking about $22, which might be enough to be concerned with.

    Unless interest rates rebound a lot, I wouldn’t worry too much about the rate of compounding in your savings account. If you have a big enough balance that it’s making a large difference, there are likely better places to keep your money than a typical savings account at a local bank. Your best approach is to simply find a bank with a good interest rate and good customer service and stick with them rather than chasing a better compounding frequency.

    [Read More: What Kind of Bank Account Is Best for Your Money?]

    Teaching son about compound interest

    Mindy writes:

    How can I teach my son about the power of compound interest? He is 6. We put some money in a savings account but it is growing slowly and he doesn’t really get it.

    Speaking from personal experience when teaching my own children this lesson, the key is to make the compounding periods small and the interest rate big so that they see what’s happening.

    For my own children, when they were very young, we illustrated compound interest with a bowl of pennies. The goal was to make compound interest as tangible and physical as possible.

    We withdrew a bunch of rolls of pennies from the bank and put a bowl of pennies out on the table, starting with 30 or so. We told them that each day, the number of pennies in the bowl would grow by 10 percent — in other words, for every 10 pennies in the bowl, we would add one penny.

    We had them guess how many pennies would be in the bowl in one month. Each night, we’d count the pennies, then we would add one penny for every 10 we counted.

    Their guesses were all super low, so they were blown away by the growth of it — the bowl was literally overflowing by the end of the month, with incredibly fast growth over the last week.

    Later, we offered them a very high weekly compound interest rate on their allowance money if they deposited it at the “Bank of Mom and Dad.” In other words, if they held their allowance in their hand and decided to deposit it with us, we would give them 5 percent interest each week on their savings. At first, our children were hesitant to take advantage of it, but when one of them started to save for a big goal and they saw how the savings were accelerating thanks to the power of compound interest, they all jumped on board. We actually had to put a cap on weekly interest!

    The message is simple. If you want your kids to learn about compound interest, make it tangible and visual. Make it important to them. Make the rate of growth rapid, so that their patience is not overly tested. Once they see the idea, it will stick with them for life.

    [Read More: Some Thoughts on Parenting and Personal Finance Success from an Experienced Parent]

    High rate of steady compound interest

    Jerry writes:

    Are there any investments that offer a high rate of steady interest? Bank accounts are so low these days and everything else is so variable.

    Unfortunately, investments that offer a very steady rate of return offer a very low rate of return these days. It’s not like it was in the late 1970s and early 1980s, when you could buy U.S. Treasurys that paid 10 percent or more. Even as recently as 2007, online bank accounts could be found that paid as much as 6 percent per year.

    Before we dig too much into this, consider why banks offer interest on bank accounts in the first place. In really simple terms, they do it because they need to have a certain amount in their vaults in order to lend out money to other customers. In essence, the money in your checking or savings account ends up being the money that banks lend out to people getting mortgages and business loans.

    The reason that you won’t find steady, solid interest rates much above 1 percent right now is because of the Federal Reserve. The Federal Reserve sets a number of interest rates that dictate how much banks can charge each other for temporary loans and how much the Federal Reserve charges them for emergency loans. If banks have access to money at the low interest rates that the Federal Reserve offers, they don’t have a whole lot of incentive to offer high interest rates to customers.

    Think about it this way. If a bank can borrow money from another bank for 0.25 percent, why would they give you much more than that in interest on your deposits? All a bank wants is money in their vaults as inexpensively as possible so they can lend it out in the form of business loans and car loans and mortgages. If they charge a lot more than 0.25 percent, they’re probably going to lose money by doing so.

    So, as long as the Federal Reserve keeps interest rates low, your bank will give you low interest rates on your savings and checking accounts. It will only go up when the Federal Reserve raises rates.

    We welcome your feedback on this article. Contact us at inquiries@thesimpledollar.com with comments or questions.

    Trent Hamm

    Founder & Columnist

    Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.