3 questions about compound interest – answered

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Compound interest is an incredibly powerful force. If you have the patience, your money can grow on its own, and returns will skyrocket over time.

While the idea is easy to understand, it can be difficult to actually apply it. Does it make a difference whether the money is put together monthly or quarterly? How do you teach the idea to young children? Are there places that offer stable compound interest with a high interest rate? Let’s dive in!

Effects of quarterly compounding banks

Angie writes:

I used to keep my savings with a bank but I didn’t like their service so I moved everything to a new bank. The new bank is great, except they only put interest on my checking account quarterly. The APR for both accounts is the same. I’m trying to figure out how much I’m losing and whether it’s worth finding another bank.

Probably not worth finding another bank if you enjoy customer service at your current bank.

Let’s say you have a huge amount of savings – $ 100,000. Let’s also assume that the bank offers an annual interest rate of 0.5 percent on its savings account, which is a reasonable amount in the current banking world. I suspect that your old bank is composed on a monthly basis, as is very common in banking, and your new bank is composed on a quarterly basis.

At your old bank, compounded monthly, you would earn interest of $ 501.15 over a year. Your new quarterly compounding bank would earn you $ 500.94 of 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 this low, different compound interest rates don’t make much of a difference. However, if interest rates bounce back sharply, then you should be careful. Let’s say the interest rate was 5 percent instead of 0.5 percent. In this case, the monthly compound account would generate interest of $ 5,116.19, while the quarterly compound account would generate interest of $ 5,094.53. All of a sudden, you’re talking about $ 22, which might be enough to make you worry.

Unless interest rates recover a quantityI wouldn’t worry about the compounding rate on your savings account. If you have funds big enough to make a big difference, there are probably better places to keep your money than a typical savings account at a local bank. Your best approach is to just find a bank with a good interest rate and good customer service and stick with them instead of pursuing a better compounding frequency.

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

Inform son about compound interest

Mindy writes:

How can I teach my son the power of compound interest? He’s 6. We put some money in a savings account, but it’s growing slowly and he’s not really getting it.

From personal experience teaching my own children in this lesson, the key is to make the interest periods small and the interest rate large so they can see what happens.

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

We pulled a few pennies off the bank and put a bowl of pennies on the table, starting at 30 or so. We told them that the number of pennies in the bowl would increase 10 percent each day – in other words, for every 10 pennies in the bowl, we would add a penny.

We had them guess how many pennies would be in the bowl in a month. Every night we counted the pennies, then we added a penny for every 10 we counted.

Their guesses were all very low so they were overwhelmed with growth – the bowl was literally overflowing at the end of the month, with incredibly rapid growth over the past week.

We later offered them a very high weekly compound interest on their bonus money if they deposited it with the Bank of Mom and Dad. In other words, if they held their allowance and decided to deposit it with us, we would give them 5 percent interest on their savings every week. At first, our children were reluctant to take advantage of this, but when one of them started saving for a big goal and they saw savings accelerate thanks to the power of compound interest, they all jumped on board. We actually had to limit the weekly interest!

The message is simple. If you want your children to learn about compound interest, make it tangible and visual. Make it important to them. Make the growth rate fast so your patience is not unduly tested. Once they see the idea, it will stay with them for a lifetime.

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

Strong compound interest with a high interest rate

Jerry writes:

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

Unfortunately, investments with a very constant rate of return offer a very low rate of return these days. It’s not like the late 1970s and early 1980s when you could buy US Treasuries that paid 10 percent or more. In 2007 online bank accounts could be found that paid up to 6 percent per year.

Before we get too into that, 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 money to other customers. Essentially, the money in your checking or savings account is the money banks lend to people who receive mortgages and business loans.

The reason you can’t find stable interest rates well above 1 percent right now is because of the Federal Reserve. The Federal Reserve sets a set of interest rates that determine how much banks can charge each other for temporary loans and how much the Federal Reserve charges them for emergency loans. When banks have access to money at the low interest rates offered by the Federal Reserve, they have little incentive to offer high interest rates to their customers.

So think about it. If one bank can borrow money from another bank for 0.25 percent, why are they giving you much more interest on your deposits? All a bank wants is money in their vaults that is as inexpensive as possible so they can borrow it in the form of business loans, car loans, and mortgages. If they charge much more than 0.25 percent, they will likely lose money doing 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 if the Federal Reserve raises interest rates.

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

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