How much interest can I earn on $1 million in 1 year?
Q: How much compound interest can I earn on $1 million in one year? Are there alternatives to savings accounts that could earn more interest?
A: The first part of your question is fairly easy to answer if you limit the options just to savings accounts.
However, the second part of your question about alternatives raises some important investment topics for an investor in your situation.
Compound Interest for $1 Million in a Savings Account
If you go to the savings accounts page of MoneyRates.com, you can see the latest information on which banks are offering the best savings account rates.
Note that these rates are quoted in terms of annual percentage yield (APY), which means they reflect what the rate would be if compounded over the course of one year.
Calculating compound interest is not hard to do. You can calculate what this would translate to in dollars using this formula:
Compound Interest Formula
Divide the APY by 100 and multiply the result by the amount you intend to invest.
For example, a 2 percent APY applied to your $1 million deposit would be calculated as:
(2/100) x 1,000,000 = 20,000
When deciding which bank to choose, you should be aware that the best savings accounts offer rates that are several times the average savings account rate (which has been under 1% for quite a while). This can make a big difference in the amount of interest you earn, especially on a large balance such as yours.
The Secret to Maximizing Compound Interest
The nature of compound interest is such that choosing the highest yield (APY) from the beginning makes for the most profit.
Particularly where large sums of money are concerned and long periods of time are involved, your investments grow the most if they earn a high interest rate from the beginning. That is why it is so important to shop for a savings account that consistently pays the highest interest from the get-go.
There are three factors that maximize compound interest.
If you want to maximize the return on your investment in a savings account, these are the three factors you need to know:
- Interest on interest
Compound interest is the earning of interest on the principal in addition to the interest earned in prior periods. Therefore, the more interest your account earns from the beginning, the more money there will be to compound in subsequent periods.
- Number of compounding periods
It's also because of time that the power of compound interest has a chance to work. Since you are earning interest on interest, the longer your money is invested, the more these earnings have the opportunity to snowball.
- Compound frequency
When bank rates are quoted in terms of simple interest rather than APY, it is also important to know how frequently interest is compounded. The more frequently interest is compounded, the more often you have the opportunity to earn interest on interest.
For multi-year periods, you can enter an APY into the MoneyRates.com compound interest calculator and assume the compounding period is annually. This can show the magnifying impact compounding can have on your earnings over longer periods.
Match Investments to Your Savings Goals
As mentioned above, shopping for the best savings accounts can really pay off if you're particular about getting the highest yields.
However, to make the most of the money you have to invest, you should first ask whether a savings account is really the right vehicle to achieve your savings goals.
The benefits of a savings account
The chief attributes of savings accounts are that they are totally safe and liquid.
1.Savings accounts are totally safe
Since the money you put on deposit is guaranteed by FDIC insurance, your principal is safe up to the legal limit of $250,000 (or $500,000 for joint accounts) per depositor.
That also acts as a limitation in your case. You would be wise to spread your million dollars around to a few banks in accounts with balances less than $250,000 each.
This is another reason to shop for the best savings account. Interest rates change frequently, and there's no guarantee that you'll earn the same interest rate at every bank.
2. Savings accounts are liquid
Your money is always available immediately, on demand. Though there are limits on the number of withdrawals you can make per month, other than that you are entitled to take out any or all of the account whenever you want. (You may be subject to some reporting restrictions by withdrawing more than $10,000 in cash at a time, however.)
The drawbacks of a savings account
The flip side is that savings accounts offer relatively low returns compared to other investments. Also, the interest rate is subject to change at any time.
If you don't need access to your money at all times, there are alternatives you can consider that might be a better fit for your savings goals.
Savings Accounts vs. Certificates of Deposit
Since your question refers to how much interest you can earn in one year, a 1-year CD might be worth considering as an alternative.
The benefits of a 1-year CD
Certificates of deposit provide the same level of safety for your principal as a savings account but offer some distinct advantages as well.
- CDs offer interest-rate security
Generally, CDs also offer a rate advantage over savings accounts. Usually, the longer the CD term, the higher the interest rate and, for periods of one year or longer, the best CD rates are often higher than the best savings account rates.
- CDs may also offer an interest-rate advantage
One advantage that certificates of deposit offer over savings accounts is that the interest rate is locked in for the entire term of the CD. While this could work against you if rates rise, at least you can know when you sign up for a CD what it will be worth when it matures.
Here again, it's important to shop around. As with savings account rates, the best CD rates are often a multiple of the category average. You can find the best CD rates on the MoneyRates CD page and easily find rates for the length of CD you want.
The drawbacks of a 1-year CD
Since longer term CDs typically offer higher rates, the only question is whether you can afford to lock your money up for a multi-year period. If you need to withdraw some or all of it after a year, a multi-year CD would not be an option because CDs generally carry a penalty for early withdrawals.
There are a handful of banks offering CDs with no early withdrawal penalty; but as of this writing, none of these no-penalty CDs are available for multi-year periods.
Still, if you are confident you won't need your money for a few years, a multi-year CD is one option to consider. The $250,000 FDIC insurance limit applies to CDs so you may need to spread your money around to CDs at different banks here too.
If you're willing to take on more risk, there are other interest-bearing investments to consider such as bonds and bond funds.
Other Interest-bearing Investments
In addition to bank deposit products, bonds are popular interest-bearing investments. These often pay higher yields than savings accounts and CDs, but they also subject you to additional risk.
Generally speaking, bonds are subject to these two types of risk:
- Interest-rate risk
Bond prices generally move in the opposite direction as interest rates. So if interest rates rise, bond prices fall. If you need all your money - principal as well as interest - within a year, you should limit yourself to a bond that matures in one year or less. Otherwise, the price of the bond may be less than the $1 million you invested when you go to access the money.
- Default risk
This is the risk that the bond issuer will not pay all of the interest or principal due on the bond. The shakier the financial situation of the issuer, the greater the risk of default.
Different types of bonds have different yield and risk characteristics. Here are three examples:
1. U.S. government bonds
Bonds backed by the U.S. government are available in lengths ranging anywhere from a month to 30 years.
As with CDs, there usually is a direct relationship between the length of the maturity date and the yield being offered. The longer the bond, the higher the income yield you're likely to get.
Unlike CDs, though, bonds fluctuate in price. So you have to worry not just about the interest rate but also about potential changes in value.
A bond backed by the U.S. government should be a very safe investment if you can wait until the maturity date. However, if you need your money sooner, the value of the bond could be down when you want to access your money.
Since these price fluctuations could exceed the value of the interest you earn, the safest thing is to choose a bond with a maturity date that is no later than when you will need your money.
2. Corporate bonds
Like government bonds, corporate bonds are subject to price fluctuations based on interest-rate changes. However, since a corporate bond is nowhere near as safe as a bond backed by the U.S. government, they also have an element of default risk.
The weaker a company's finances, the more risk there is that they won't be able to pay all the interest or principal on their bonds. Even if a company doesn't actually default, just the fear that it might could send a corporate bond's price lower.
You will likely find that corporate bonds offer more attractive yields than U.S. Government bonds, but keep in mind that this comes with added risk of temporary or permanent losses.
3. Foreign bonds
Foreign bonds are subject to both interest-rate and default risk - but they add a third dimension of risk: currency risk. If a bond pays interest and principal in euros and you are a U.S. investor, then the value of your return declines if the value of the euro declines relative to the dollar. On the other hand, you could benefit if the euro does well compared to the dollar. It is important to thoroughly understand currency risk and economic factors in the issuing country before you buy a foreign bond.
As always, there is a relationship between risk and potential reward. Besides the characteristics of the specific instruments, risk is often affected by your time horizon.
If you are investing for a long-term goal such as retirement, you can be more tolerant of investments that fluctuate in value from year to year as long as they make money over the long run.
On the other hand, if your time horizon is shorter, you are better off sacrificing the chance of higher returns for the sake of stability. So, where you go from here is, first, to decide how much risk your savings goals can bear. Then shop around for the best opportunity offered by that type of investment.
MoneyRates.com invites you to submit your questions to its "Ask the Expert" feature.