Interest Shminterest: It's The Compounding That Matters

On Banking

May 6, 1996|ROBERT K. HEADY

You want to wring every extra nickel you can out of low-paying bank CDs, don't you? Then look at how your investments are compounded.

What's compounding? It's probably the least understood thing about the banking world because it involves boring mathematics. But in some cases, it can make a healthy difference in the amount of interest you earn.

Don't worry if you're not a numbers whiz. Anyone with a junior-high-school education can figure which compounding deal is best by just remembering three basic tenets:

-- Compounding simply is interest added to interest.

-- The more frequently the bank compounds your interest, the better. All things being equal, daily compounding is better than monthly compounding, monthly is better than quarterly and so on.

-- The longer the CD term, the more compounding is important to your pocketbook.

Just how much more you'll earn under one compounding method vs. another depends on how much money you invest and for how long.

Let's say you have $10,000 to invest in a six-month CD. Four banks offer you the same interest rate - 5 percent - but they use different compounding methods. Here's how much you'd earn on the account at each of those outfits:

Bank A pays only simple interest, which means the account isn't compounded at all. You earn half of the 5 percent annual interest because the CD is for only six months. So your interest comes to $250 (0.05 times $10,000 divided by 2).

Bank B compounds quarterly. Total interest: $251.56.

Bank C compounds monthly: $252.62.

Bank D compounds daily: $252.43.

As you can see, the difference between the worst method and the best method is less than $3. That's piddling, considering that you're depositing $10,000. But so what? Better you get the extra pocket change instead of letting the bank keep it.

It also appears from our example that monthly compounding pays more than daily compounding. Didn't we just say that the more frequent the compounding, the better? Yes, but we purposely threw in a deception to show you a trick banks use in playing with the numbers.

For the calculations, we assumed there were 182 days in the six-month term.

Had we chosen 183 days, the total interest from daily compounding would have been $253.84.

So it's clear that with shorter-term CDs like the six-month, interest compounding amounts to peanuts. It's less important than the rate. In the examples we used, you would have been better off shopping for a higher rate, such as 5.25 percent, even if the account paid only simple interest.

The bucks can really add up on long-term CDs, where interest has time to pile on top of interest. Let's take the same four banks again, this time with a 6 percent rate and a five-year CD. Assume you're still investing $10,000:

Bank A: Simple interest, $3,000.

Bank B: Quarterly compounding, $3,468.55.

Bank C: Monthly compounding, $3,488.50.

Bank D: Daily compounding, $3,498.25.

Here, the spread between Bank A and D is almost $500. That's an average of $100 per year over the five-year term, which is a significant 1 percent of the amount invested.

Two other notes on the subject:

-- You may have encountered banks that say they compound continuously, as though they've got some little guy in the basement cranking out extra interest for you every second. Don't be fooled by that ploy. "Continuously" sounds better than "daily" but produces little, if any, more than daily compounding.

-- Some institutions compound on what they call a 365/360 basis. They juice up the yield with a bit of tricky math. Instead of dividing the rate by 365 days in a year and compounding it 365 times in that year, they divide it by 360 and compound it for 365 days.

Why 360? Because that number is the equivalent of 12 months with 30 days each.

Result: You wind up with more interest in your account because of the five extra days of compounding.

Latest rate trend: Savings yields remained nearly flat, as mortgage rates jumped by 0.1 percentage point to 8.01 percent on a 30-year fixed-rate loan.


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