The Potential and Pitfalls of Compound Interest

Did you recently choose the best savings account for a large lump sum?

A quarter percent difference in interest is 25 points, but if you compound that interest frequently enough then those 25 points can make a pretty big difference on your Effective Annual Rate down the road.

For instance:

$10K for 1 year @ 2% (compounding quarterly) earns $201.00
$10K for 1 year @ 2.25% (same compounding) earns $226.91

But…

$10K for 10 years @ 2% (same) earns $2207.94
$10K for 10 years @ 2.25% (same) earns $2515.33

More than $300 difference on a .25% EAR. Also sometimes called the ARY. The Annual Rate Yield.

Example provided for educational purposes only. Check out all of our rates here.

And here is where our conversation begins. Depositing a large lump sum in a savings account with a quarter percent higher return is worth it if you have a large lump sum that you want to park for another 10 years. But if you have a large lump sum and you’re thinking of doing something with it in the next year, it makes sense to find an interest rate that compounds in your favor all the same. We provide a calculator for just that purpose, right here.

woman checking figures

Shopping around for the best rates on savings accounts is smart if you’re looking to deposit a large lump sum that way, that’s undeniable.

Compound interest affects consumer spending habits in almost every observable economic transaction; for example: credit cards. Many people develop complex and risky payment strategies in order to avoid the charges that come when an interest rate is triggered that compounds daily.

What is your particular strategy for paying interest charges on a credit card? Minimum monthly? Same flat amount every time? Balloon payment on birthdays? How about the APR on a family’s second car? Or the EAR at your financial institution on deposits over $5,000?

One factor that might influence your payment plan is how often the interest gets compounded. Compound Interest means interest on interest. Compound Interest means that interest calculated on a principal sum is added back into the sum. In large part, the various interest rates you get for having credit cards, auto loans and savings accounts are all major influences in guiding your financial appetite for risk and reward.

If you can afford it, you can enjoy the convenience, ease and universal acceptability that comes with a credit card. If your budget finances are lower, a credit card can be a financial lifesaver in times of crisis and can make the difference in making ends meet. Of course, one foolproof way to avoid any and all monthly interest charges on your credit card is to pay your balance in full every month. Calculated any way you look at it, that’s a nominal rate, an annual rate and an effective annual percentage rate of absolutely zero.

But life is an up and down journey, and sometimes the convenience of credit is worth a solid monthly payment plan.

woman computing interest
The Pitfalls

Example 1

Let’s say you borrow $2,000 over a 3 year period, pay 10% annual interest on your debt and are not making regular repayments. In this case, the amount you will have to repay will look like this:

Year 1: $2,000 x 10% = $200
Year 2: $2,200 x 10% = $220
Year 3: $2,420 x 10% = $242

The total repayment figure after 3 years is $2,662 (the $662 interest is the sum of each year’s interest). It should be noted that if you make regular repayments on your loan, the total compound interest will be lower because the remaining principal on the loan will be decreasing at each compound interval.

We have a loan calculator here if you want to try out some figures.

Example provided for educational purposes only. Check out all of our rates here.

Example 2

Let’s look at it with a simple $500 yearly repayment figure added in:

Year 1: $2,000 x 10% = $200. Total is now $2,200.
Year 2: ($2,200 – $500) x 10% = $170. Total is now $1,870.
Year 3: ($1,870 – $500) x 10% = $137. Total is now $1,507.

The total repayment figure after 3 years stands at $1,507 and the interest paid by the end of year 3 is $507.

Example provided for educational purposes only. Check out all of our rates here.

The Potential

Now here’s the good news, compound interest can also work in your favor.

A savings account for large lump sums with a higher APY and higher earning potential is available at DECU, where we’re proud of our Best In Market Rates* and just how much more DECU members earn thanks to our Best In Market Rates.

At DECU we have built a free application into our website that will calculate the Annual Percentage Yield on your savings deposit.

If you’re looking for a loan or considering a new credit card, you need to know how often your interest compounds, so that you can determine what your payments will be if you choose to carry your balance forward.

We also provide a clear, simple and easy-to-read chart showing exactly what the APR range is for our DECU credit cards**, and how frequently the interest is compounded.

At DECU we are proud to offer Best in Market rates on our loan products based on a weekly Market Rate Survey by www.Rate-Watch.com and www.BankRate.com*.

* Based on a weekly Market Rate Survey by www.Rate-Watch.com and www.BankRate.com. Federally Insured by NCUA.
** Subject to credit approval.