Compounding Interest Daily vs. Monthly: What’s Better for Your Savings?

When you open a savings account, CD, or another interest-bearing account, you’ll see a lot of information surrounding how interest is paid.

You might see some that advertise daily or monthly compounding mixed in with terms such as "APR" and "APY."

Knowing what all these different things mean can be difficult, but it’s important if you want to know how the account will actually pay interest.

Learn the differences between all this money jargon to see how they really matter to you.


APR vs. APY

Before we jump into daily and monthly compounding, we must explain why either of them matter.

The two terms are related to "APR" and "APY," which are both commonly used acronyms that describe the interest that an account pays.

Annual percentage rate (APR)

The APR helps to calculate the simple interest that is earned on an investment.

This figure is used to determine the exact interest to be accrued by (not credited to) your account, depending on the rate of compounding (daily vs. monthly).

It does not reflect the exact percentage return of your deposits on an annual basis because it does not take effect of compounding into account (the APY does).

If a savings account has a 2.00% APY, the APR can be different depending on the rate of compounding:

  • Daily: 1.98032% APR
  • Monthly: 1.98190% APR

More on daily vs. monthly compounding below.

Annual percentage yield (APY)

The APY on an investment is the effective annual return on your balance, including the effect of compounding.

If you have $100 in an account with an APY of 2.00%, you’ll have exactly $102 one year later.

You can calculate the APY of an account using the following formula, where m is the rate of compounding (365 for daily or 12 for monthly):

  • APY = m   -    1

In short, the APY of an account will always be higher than the APR of that same account.

This is because the APY uses the compounding schedule of the account in the equation. APR does not.

Use an APY calculator to calculate your savings growth over time.

Daily Compounding

When an account advertises daily compounding, it is calculating interest earnings on your account on a daily basis.

However, you might not see the money credited to your account every day.

Let’s say you have a savings account with an APR of 2%. If interest is compounding daily, that means that there are 365 periods per year and that the periodic interest rate is .00548%.

The APY on the account would be:

  • (1 + 2.00/365)365 – 1 = 2.02% APY

This is very slightly higher than an account that compounds your money once every month.

Monthly Compounding

With monthly compounding, the bank will calculate interest on your account just once per month.

It will not update your balance on a daily basis when it calculates how much interest it owes you.

Assuming that the APR is the same, accounts with monthly compounding offer a lower APY than accounts with daily compounding.

Returning to our previous example of an account with an APR of 2%, the APY of the account would be:

  • (1 + 2.00/12)12 – 1 = 2.01% APY

In reality, it is much less than a difference of 0.01% compared to daily compounding.

The minuscule difference in interest will have little effect on how much interest you earn unless you have a very large balance.

What Happens If Balances Change During the Month

If you move money in and out of your savings account, you might wonder how it will affect the interest that you’re paid.

In fact, there’s relatively little difference in how moving money affects the accrual of interest whether interest is compounding daily or monthly.

With both types of compounding, the interest you earn is usually calculated on a daily basis based on the end-of-day balance (the time cutoff varies by bank).

If you have $5,000 in your account on Monday, either type of account will calculate how much interest you are owed for the day.

If you move $3,000 out of the account on Tuesday, leaving a $2,000 balance, both types of account will use that new balance in their interest calculations for that day.

The difference is that for accounts that compound monthly, the interest owed for Tuesday will be calculated on just the $2,000 balance.

For an account that compounds daily, interest will be calculated based on the $2,000 balance, plus the interest owed from Monday.

Does It Matter?

As you’ve probably gathered by now, the difference between daily and monthly compounding is not significant.

Unless you have hundreds of thousands of dollars in your account, the difference will be fractions of a penny.

While finding an account that compounds daily will give you a slightly larger return on your savings, it’s not significant enough to be a selling point when comparing banks.

Consider this example:

You have $100,000 in your savings account, which has an APR of 5%. This savings account compounds interest every month.

After ten years, your account’s balance will have grown to $164,700.95. You’ll have earned $64,700.95 in interest.

If instead, you had placed the money into an account with an APR of 5% and daily compounding, you’d have $164,866.48 after the end of 10 years.

Of that amount, $64,866.48 will have been earned as interest.

Over the course of 10 years, the difference between daily and monthly compounding on a $100,000 balance is less than $200, 0.2% of the initial balance.

In the end, the difference between monthly and daily compounding is negligible. Again, focus on the APY.


Don’t Confuse Accrual and Compounding

One thing to remember is that you should not confuse accrual and compounding.

Almost every bank will only pay out accrued interest on a monthly basis when your statement period closes. That does not mean that all banks will compound your interest monthly.

Banks that compound your interest daily will, in effect, track two balances for your account.

One balance will be the one that you can see, which is the amount of money available to you for withdrawal.

The second is that amount, plus any interest that you’ve since the last time that interest was deposited into your account.

When calculating how much interest is accrued each day, the bank will use the second number, which will be larger than your visible balance.

This is how the bank can compound interest daily without making daily deposits to your account.


Banks Advertise APY, Not APR

When they advertise their deposit accounts, banks will always advertise APY because the number will be higher.

Since customers want to earn more interest on their savings, banks will use the larger number where they can.

A benefit of this is that the APY of a deposit account takes the compounding schedule into account.

You can ignore how often an account compounds interest and just look at the APY that the account offers.

An account with an APY of 2.00% that compounds interest annually will still offer a better return than an account that has an APY of 1.99% with daily compounding.

By contrast, banks usually advertise the APR, not APY on loans, because the APR will be lower. That makes it look like they charge less interest.


Conclusion

The difference between daily and monthly compounding interest is largely insignificant unless you have a huge balance in your account.

In the vast majority of cases, the difference isn’t a selling point and should not factor into your decision when you compare banks.

What you should be focusing on when comparing accounts is the APY.

The APY is the true annual return on your deposit, and it accounts for whether the account compounds daily or monthly.

If two accounts, one which compounds daily and one which compounds monthly have the same APR, the one that compounds daily will have a higher APY.

Looking for a higher APY means you don’t have to worry about how often interest compounds.

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Oxford2947
Thursday, 16 May 2019 5:12 PM
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