How much of a difference will the rate make?

Potential rate of return on various accounts

Amount you have deposited

Option 1

Option 2

Option 3

Option 4

"How much of a difference will the rate make?" shows the benefits of compounding over a range of saving periods. You enter an interest rate that you expect to earn on your deposits. The calculator assumes you are using a tax-advantaged account.

Compounding is the process of adding interest to your original deposit and contributing the sum for another identical period. The more frequent the compounding, the greater the future value. Similarly, the higher your savings interest rate, the greater the future value of your savings.

For example, if you keep a deposit of $1,000 in an account for one year at 12%, compounded once a year, your future value in one year is $1,120. You earn $120 in interest. If you keep the deposit in the account for two years, the future value is $1,254, to the nearest dollar. Your second year earns $134 in interest with no additional contributions. In addition, if you compound four times a year instead of once, your $1,000 deposit grows to $1,126 -- an extra $6 -- in one year. The calculator uses monthly compounding.

Compounding frequency:The frequency that a bank compounds interest on your deposit. Banks and financial institutions routinely use compounding to pay you a higher interest rate. For example, a bank may be offering a CD that pays interest at 10%. If the bank does not compound interest, you will receive 10 percent of your investment as interest income at the end of a year. But if the bank compounds interest every three months (quarterly compounding), you will earn an interest rate of 10.38%. If the bank compounds interest monthly, you will earn 10.47%. And if it compounds daily, you will earn 10.52%. For a $10,000 deposit, this is an extra $52 in interest that you earn.

Future value:The future value is the amount that your investment grows to in the future. For example, the future value of $100 invested at 8% at the end of each month is $1,245 after 12 months. The present value, or value of this future value in today's dollars, depends on the discount rate. Often, the discount rate used is the same rate as the rate of return, or 8%. The present value of $1,245 discounted at 8% is $1,153. If you were to invest $1,153 today at 8%, this would grow to $1,245 in one year. In other words, you can invest $100 a month for the next 12 months or $1,153 today to obtain the same future value.

Tax-advantaged account:A tax-advantaged account is an investment account with tax-deferred or tax-exempt features. The Internal Revenue Service authorizes the use of tax-advantaged accounts. These accounts are used to save for retirement or college and other educational expenses. Tax-advantaged accounts are tax-exempt until you take money out of the account. In some cases, distributions are tax-exempt provided the account holder meet certain conditions or the money is spent a certain way. In other cases, the entire amount of the distribution is taxable.

Savings interest rate:The savings interest rate is the yearly interest rate you earn on your savings. It is also used to calculate the opportunity cost of paying with cash. In contrast, the saving rate is the percentage of income you save.

Compounding:Compounding adds the interest you earn on an investment and invests it, plus the original investment, for another period. The result is that you earn more interest and a higher rate of return. For example, if you invest $10,000 at 10% for one year with no compounding, you would receive $1,000 in interest at the end of the year. But if the bank compounded your interest every three months, you would earn $250 after the first three months, which is added to the original deposit of $10,000 and invested for another three months. After three more months, your $10,250 investment would earn $256.25 in interest. The process is repeated so that at the end of the year you earn $1,038 in interest. This is $38 more than if there were no compounding. Compounding is also determined by the frequency that you roll over the interest. For example, a bank may offer 10% on a one-year $10,000 CD. If there is no compounding, you will receive $1,000 in interest at the end of the term. If interest is compounded every three months, the rate is 10.38%. If compounded monthly, the rate is 10.47%. If compounded daily, the rate is 10.52%. For a $10,000 deposit, an extra 52 basis points in the interest rate is equal to an extra $52 in interest.