Do Banks Compound Monthly or Daily?
- Banks almost always quote interest rates as an annual percentage rate, or APR. This rate only takes into account the interest earned on the principal money for a period of a year; it does not take into account the interest earned on the accumulated interest in the account. Alongside the APR, some banks also quote an annual percentage yield, or APY, which does take compound interest into account. To calculate daily interest, banks divide the APR by 365 days (or 366 in a leap year).
- Save early to maximize the effects of compounding.Comstock/Comstock/Getty Images
Interest is compound when the interest earned in one period becomes part of the principal for the next period -- in effect, earning interest on interest. This is referred to as compound interest because of its exponential growth. The interest-on-interest component can grow over time to dwarf the amount of interest charged against the original principal deposit. The more often interest is compounded, the more interest is charged. Banks add the interest of a given day to the next day's balance; thus, interest compounds daily. Earned interest is not reflected in the account, however, until the end of the monthly period. - For basic savings accounts, banks multiply the daily rate by the daily account balance: This is the daily balance method. For other savings accounts, an average daily balance is computed as the sum of all daily balances in a given monthly period, divided by the number of days in that period: This is the average daily balance method. Banks use the latter approach for savings accounts with stepped interest rate schemes, in which the interest rate rises with the balance in the account.
- You just opened a Day-To-Day Savings account and deposited $100. After two days, you deposit an additional $100; you then withdraw $50 three days later. In the first 30 days, the account held $100 for two days, $200 for three days, and $150 for 25 days. Because interest is calculated and compounded daily, you actually earned interest on the $50 there only for three days. Assuming an APR of 3 percent and a 365-day year, your first interest credit into the account is around $0.37; the balance by end of the first month is $150.37.
