How daily compound interest works
and who uses it

Daily compound interest is one form of the basic principle of compound interest that is used throughout your daily financial transactions.

This type of interest happens to be a little more confusing than other types, though, so here's a brief explanation of how it works and how it's used.

Basically, when interest compounds, that means you earn or owe interest on the interest, and not just the amount you have in the bank or the amount you borrowed. For instance, on a credit card that's carrying a balance, you'll have an interest rate. If that interest rate is compounded monthly, then each month, the company will calculate your interest and add it to your balance. Say your interest is £13.

Then that £13 will be added to your principle balance, and next month, you'll also pay interest on that too. In this case, compound interest works against you, but when you're saving, it works for you.

Why is daily compound interest used?

Much of the time, interest is calculated annually or monthly, but sometimes daily compound interest is used. It's mostly used in situations where the financial situation may change daily.

Either the principle balance of the account changes rapidly or the actual interest charged or earned changes frequently, such as in the case of liquid savings accounts or stocks.

Who uses it?

Mainly, only financial companies use daily compound interest frequently, since it is most often used for products like stocks and shares that can be bought and sold rapidly. Some mortgages, like tracker mortgages, also compound interest in this way. There are even some savings accounts out there that compound interest on a daily instead of a monthly basis.

Why does it matter?

For you, it really shouldn’t matter all that much. In the UK, the Office of Fair Trading has set out to protect non-maths-whizzes by setting up some rules about compound interest. Basically, instead of being told what your account may or may not compound daily or monthly, you’re given a percentage rate followed by either APR or AER. These terms refer to the interest per year, regardless of the monthly or daily interest rates; they also include one off set up charges or fees. These terms make it easier for you to compare accounts on a yearly basis, even if banks still actually use daily or monthly interest.

APR stands for Annual Percentage Rate. Basically, this is the yearly rate that you’ll pay on your credit card or loan. If you pay a 5% APR, then you’ll owe an additional 5% of your balance per year. It takes into consideration any interest figured out daily or monthly.

AER stands for Annual Equivalent Rate. It is used for money you’re getting in a savings account, rather than money you owe on a loan. Basically it accounts for any monthly or daily interest, even though it might only be added yearly.

How daily compound interest works

You would think that whatever your APR or AER is, would be divided by 365 days to give you your daily compound interest, but this is actually not quite the case. Daily interest is close to 1/365th of your annual interest, but the complex formula used doesn’t always turn it out in exactly that way.

For instance, instinct would tell you that the daily interest rate on an account with an 8% APR would be .02192% because that is 8%/365 days. However, the actual daily interest in this case is .02109%. .

Also, remember that since your interest is compounded every day, each day you’re earning a little more interest than the day before because yesterday’s interest has been compounded into your balance.