What Is Compound Interest/Dividends?

Consider this scenario: you’ve got a little money to set aside, but you want to make sure it’s liquid for a rainy day. You could toss it in your sock drawer, but a high-yield savings account might be a better option because of compound interest. You may be surprised to learn just how much money your savings can generate — given enough time — through the power of compound interest/dividends.

What Is Compound Interest?

Banks and credit unions essentially borrow money from their members (the money you keep in your account) to make loans, and interest/dividends is what they pay in exchange for the right to loan that money. At banks, you’ll hear the term “interest,” and at credit unions, you’ll hear “dividends.”

Money in your savings account can either earn compound interest or simple interest. Compound interest means you earn dividends both on the original amount you deposited in the account (your principal) and the dividends you earned on that principal in previous months. This snowball effect of adding interest to your principal can provide significant returns on your deposits the longer you keep your money in the account.

Why Do Credit Unions Call Interest “Dividends”?

People who put their money into a credit union become both members and shareholders in that credit union. They gain the right to vote on decisions, elect leadership, and influence their financial institution.

When the credit union profits, those profits are split between credit union members the same way that shareholders get money from stock. That’s why credit unions refer to interest gained on checking and savings accounts as dividends.

How Does Compound Interest Work?

Let's say you deposit $1,000 into a savings account that compounds at a rate of 1.5% annually. You'll earn $15 in returns on that deposit in year one. In year two, you'll earn 1.5% on $1,015, bringing your total to $1,030.22. Over 10 years, you would generate just over $1,160 on that initial $1,000 deposit. Investor.gov has a calculator if you want to explore more variables.

Understanding Compounding Schedules

Interest-bearing accounts have two schedules, one for how often interest compounds and one for when your credit union or bank pays you that interest.

For instance, most institutions now compound interest daily, but you probably receive the interest monthly, quarterly, or annually. Once the new money is added to your account, you’ll start to accrue interest on that money as well.

Interest Rates vs. APY

An interest rate is the amount of interest your money earns expressed as a percent or a decimal percent, such as 1.5% or 2%. But the interest rate only tells part of the story. The other important factor is your account’s compounding schedule. When all other factors are the same, a faster compounding schedule leads to faster growth.

Annual percentage yield (APY) tells a more complete story. It provides an estimate of what your account will earn in one year including the compounded interest. But why does this matter? It’s possible for an account to offer the same (or higher) interest rate but less frequent compounding, leading to smaller gains than an account with more frequent compounding. The chart below illustrates this.

Difference in Compounding Annually and Compounding Monthly on $5,000 at 1.5% APY

What Kind of Accounts Use Compound Interest or Dividends?

Savings accounts aren’t the only type of account that uses compound interest. Some interest-bearing checking accounts also use compound interest, as well as many investment accounts like:

• Certificates

• Money market accounts

• Bonds and bond funds

• Brokerage accounts opting into a dividend reinvestment plan (DRIP), where dividends are re-invested in the same stocks

Be aware that not every interest-bearing account compounds interest. Instead, some feature what is called "simple interest." Your interest rate (or dividend rate at credit unions) is listed on your account statement or in your mobile banking app.

It may be listed as your account’s APY, or annual percentage yield. If you’re opening a new account, the interest rate and whether it’s compounded should be listed in paperwork provided by your bank or credit union, but you can also ask when comparing account types.

Simple Interest vs. Compound Interest

Some financial institutions may offer a very high-sounding rate on a savings or checking account to lure you in as a new customer. Be sure to check the fine print. It's possible — maybe even likely — that the financial institution is offering a high rate on a "simple interest" account.

With this kind of account, you earn on your initial and subsequent deposits. The downside is that the interest/dividends you earn will never accrue their own interest or dividends. This may not seem like a big deal in the short-term. However, in the long run, it can make a big difference to your bottom line.

How Much of a Difference Does Compound Interest Make?

Imagine you have $3,000 each in two savings accounts. Both earn 2% interest, but one earns simple interest while the other earns compound interest. In five years, the account with simple interest would earn $300, while the account with compound interest would have earned $315.24. As you can see from the chart below, the difference in earned interest will continue to grow over time.

Difference in Simple Interest and Compound Interest Earnings on $3,000 at 2% APY

Tips for Maximizing Compound Interest

Now that you understand compound interest, let’s think about ways to maximize compounding for wealth building. That way you’ll get the most benefit from saving.

Start Saving Early

Time is the biggest factor with compound interest. The longer you save, the more interest/dividends you’ll accrue — and the more that accrues, the larger principal you’ll earn interest/dividends on. This is why it’s so important to teach your children the importance of saving or to start saving for retirement in your twenties.

Compare the APY Instead of Interest Rates

When comparing two savings products, it’s tempting to jump at the one with the higher interest rate. But hold on! A high interest rate that compounds infrequently could earn less than a smaller interest rate that compounds more frequently. Instead, look at the annual percentage yield (APY) of both accounts for a truer sense of what each account will earn.

Choose the Right Savings Tool

You’ve got a lot of great savings tools available, from high-yield savings accounts and certificates to more ambitious tools like retirement and brokerage accounts. Some will offer higher rewards — along with higher risks. What’s important is you choose the tool that suits your needs. Not sure where to start? Consider:

• How liquid or illiquid you need your money to be

• Whether small, steady gains are worth it, or whether you need more aggressive gains

• What kind of strategies you’re willing to adopt and stick with

• Whether you’re happy saving small amounts or willing to use passive income or a side hustle to save larger amounts

The Takeaway

Understanding the difference between simple and compound interest is more than a homework problem. It’s an important concept for choosing the right savings tools to reach your financial goals. Calculating variables like the amount of your initial deposit and how regularly you'll make future deposits or withdrawals, as well as how long you plan to keep your money in a savings account, will help you put your money to work the right way.