What is Capitalised Interest on Savings?
Capitalised interest on savings refers to the practice of adding the interest earned on a savings account to the principal amount of the account. This means that the interest is not paid out to the account holder, but instead, it is added to the initial deposit, thereby increasing the total balance. This method of accounting for interest is often used by financial institutions and can have significant implications for the growth of an individual’s savings over time.
In simple terms, when interest is capitalised, it is considered as part of the principal, and any subsequent interest calculations are based on the new, higher principal amount. This approach can lead to exponential growth in the account balance, as the interest earned in each period is based on a larger principal amount than the previous period.
How does Capitalised Interest Work?
The process of capitalising interest is straightforward. When an account holder earns interest on their savings, the financial institution will calculate the interest earned based on the current principal amount. Instead of crediting the interest to the account holder’s balance, the institution will add this interest to the principal, resulting in a new, higher principal amount.
For example, if an account holder has a savings account with an initial deposit of $10,000 and an annual interest rate of 5%, the interest earned in the first year would be $500. If this interest is capitalised, the new principal amount would be $10,500. In the second year, the interest calculation would be based on this new principal amount, resulting in a higher interest payment.
Benefits and Drawbacks of Capitalised Interest
There are several benefits and drawbacks to capitalising interest on savings accounts.
Benefits:
1. Enhanced Growth: Capitalising interest can lead to exponential growth in the account balance, as the interest earned in each period is based on a larger principal amount.
2. Simplicity: The process of capitalising interest is straightforward and easy to understand.
3. No Additional Work: Account holders do not need to do anything extra to capitalise their interest; it is automatically included in the account balance.
Drawbacks:
1. Lower Liquidity: Capitalising interest may reduce the liquidity of the account, as the interest earned is not immediately available for withdrawal.
2. Missed Opportunities: Account holders may miss out on the potential benefits of reinvesting the interest earned, as it is added to the principal rather than being paid out.
3. Confusion: Some account holders may find it confusing to understand how their account balances are growing, as the interest is not paid out separately.
Conclusion
Capitalised interest on savings is a method of accounting that can significantly impact the growth of an individual’s savings account. While it offers the potential for enhanced growth and simplicity, it also has drawbacks, such as reduced liquidity and missed investment opportunities. Understanding how capitalised interest works is essential for making informed decisions about managing savings accounts.
