A Daily Compound vs. a Semi-Annual Compound Savings Account
Compound interest earned on your savings account is the interest you earn from the money you deposited into the account and the interest you earn on the interest. Interest that compounds daily on your savings account earns a little bit more than interest compounded semi-annually.
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Compound Interest
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The best way to explain how compound interest works is by using numbers. Say you deposit $1,000 into a savings account that earns 2 percent interest that compounds annually or once per year. At the end of year one, the amount of interest you earned on your $1,000 deposit is $1,000 x .02 = $20. In the beginning of year two, you earn interest on your $1,000 deposit, plus the $20 you earned in year one. At the beginning of year two, your savings account balance is $1,020, earning two percent interest. By the end of year two you will have earned an additional $20.40 ($1,020 x .02 = $20.40).
Daily Compounding
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Daily compounding basically means that you earn interest on your savings account every day. How this works is first the bank gives you an annual percentage yield (APY) on your savings account. Then, you divide the APY percentage by 365 to determine how much interest your money earns daily. So, a savings account with a 5 percent APY earns 0.0137 percent interest every day (0.05 / 365).
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Semi-Annual Compounding
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Semi-annual interest compounds once every six months or twice per year. A savings account with a 5 percent APY that compounds semi-annually earns you 2.5 percent interest every six months (0.05 / 2 = 2.5 percent). So, if you deposit $1,000 in a savings account with a five percent APY, at the end of the first six months, you begin earning interest on your initial $1,000 plus the interest you have earned on that deposit.
Comparison
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To illustrate the earning difference between daily and semi-annual compounding, say you deposit $1,000 in two savings accounts, both with a five percent APY. One compounds daily and the other annually. The daily compounding account earns you 0.027 percent daily and the semi-annual account earns you five percent every six months. At the end of the first six months, the daily account earns you $1,000 x (1 + .05 / 180) raised to the power ( ^ ) of 180 = $1,051.26 and the semi-annual account earns you $1,000 x (1 + .05/2) ^2 = $1,050.63.
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