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What is Compound Interest/Dividends and How Does It Work?

What you'll learn: What to know about compounded earnings

EXPECTED READ TIME:3 MINUTES

Consider this scenario: you've got a little money to set aside, but you want to make sure it's available for a rainy day. A high-yield savings account might be right for you.

As you begin your search, you may find savings accounts that contain a compounding feature. But what is compound interest/dividends, and how does it work?

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/Dividends?

To sum it up, interest (or dividends if you bank at a credit union) on a deposit compounds based on both the initial principal and the accumulated interest/dividends from previous periods. In short, with compound interest/dividends, you earn interest/dividends on your interest/dividends — not just your deposits. This snowball effect can provide significant returns on your deposit, the longer you keep your money in the account.

How Does Compound Interest/Dividends 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.

Understand Compounding Schedules

These days, you're likely to find that most credit union and bank accounts offer compounding that sticks to a standard schedule. Your money compounds daily. Every month or so, the new money you gained will be added to your account. Once the new money is added you'll start to accrue interest/dividends on that money as well.

What Kind of Accounts Use the Power of Compound Interest or Dividends?

Now that you understand the power of compounding, maybe you decide a savings account with compound interest/dividends is the right place for your money. Beware not every savings account compounds. Instead, some feature what is called "simple interest."

Know the Difference Between Simple Interest and Compounding

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 its 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.

Which Savings Account is Right for You?

Deciding which kind of savings account is right for you means calculating variables like the amount of your initial deposit and how regularly you'll make future deposits or withdrawals. One of the biggest factors will be how long you plan to keep your money in a savings account.

If you want to grow your money effectively over time, knowing what compound interest/dividends is and understanding how to use the power of compounding will help you tremendously.

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