Compounding Frequency

When interest compounds, it is added to the balance and then starts earning interest itself. The more often this happens, the sooner each bit of interest begins earning more, so the balance grows slightly faster.

Take 10,000 at a stated rate of 12% a year. With yearly compounding, interest is added once and the balance after one year is 11,200. With monthly compounding, 1% is added each month, and the balance after a year is about 11,268. With daily compounding, it is about 11,275.

The difference between monthly and daily compounding is small, but the jump from yearly to more frequent compounding is noticeable, especially at high rates and over long periods.

This is why two accounts with the same stated rate can pay different amounts. Lenders and banks often quote an effective rate, such as the APY or the effective annual rate, which already includes the effect of compounding frequency, so products can be compared fairly. Borrowers should check compounding too: a credit card that compounds monthly costs more than its headline rate suggests.