Albert Einstein reportedly called compound interest mankind's "greatest invention." While there's a question as to whether Einstein actually uttered those words, there's no question about the power of compound interest to multiply investment returns far faster than can be achieved through simple interest. There are several major types of investments that earn compound interest, including ordinary accounts that you can open at nearly any bank or credit union in the country.
Compound interest refers to fractional interest payments made repeatedly during a year. It is distinct from simple interest, which is paid once a year. Compound interest is cumulative, that is, interest is paid both on the principal (the amount of money invested) as well as on accumulated interest, meaning that an account that compounds interest more frequently earns you more money as the account holder.
Compound interest can be paid semi-annually in two fractional payments, or in any other fraction of a year. Compound interest is often paid monthly or daily. Some accounts pay compound interest continuously using mathematical formulas to calculate the interest that would be paid if the year were divided into an infinite number of infinitesimal interest payments. Financial spreadsheets and calculators have a built-in function for calculating compound interest. You can also find calculators on the web to determine how much interest you'd earn under different compounding scenarios.
Banks and Credit Unions
Many banks and credit unions pay compound interest on their savings accounts and checking accounts. Many money market funds, provided by banks as well as other financial institutions like brokerages, also pay compound interest rates.
Zero-coupon bonds often pay compound interest rates. Zero coupon bonds are bonds that are purchased at a discount from face value, accumulate interest over the life of the bond and pay out at face value when the bond is redeemed. The accumulated interest generally accrues by compound interest, even though it's only actually delivered to the bond's owner once at the maturity date.
Five Percent Account
A $10,000 investment in an account that pays 5 percent interest annually will earn $500 after a year of simple interest. If the account pays compound interest semi-annually, the investment will earn $506.25. Daily compounding will yield $512.67 and continuous compounding earns $512.71.
As the amount of money you're investing goes up, compound interest plans can make a bigger difference to your ultimate earnings, so it's a good idea to make sure you understand how compounding works for your investments and bank accounts.