How Does Interest Work on a Savings Account? - SmartAsset

Most of us know that a savings account is a smart place to store money. Savings accounts have higher interest rates than checking accounts and, as such, help us earn more without sacrificing liquidity. And although they yield lower returns than most other investments, they are much lower risk. Yet even though savings accounts are part of most Americans’ financial plans, many of us don’t understand how the interest rates they offer work. Understanding this key element of your savings account is important to help ensure you’re making the most of your earnings. A financial advisor can offer valuable insights into managing your money.

Interest Explained

Interest is essentially the amount of money paid in exchange for borrowing someone else’s money. This compensation both accounts for the risk of lending money and provides an incentive for lending. It’s generally calculated as an annual percentage of a loan or balance and paid to the lender at agreed-upon rates. Interest can also be based on longer or shorter terms.

You may be familiar with the concept of an annual percentage rate (APR) from your monthly credit card statements or student loan paperwork. That’s interest that you pay as the borrower, in addition to the principal amount of the loan. Annual percentage yield (APY), on the other hand, is interest you earn for lending your money. It conveys your rate of return for the year. In addition to helping you grow wealth, APY can encourage better savings behavior.

Interest amounts are usually determined by the original amount of the loan, the interest rate and the length of time it takes you or your borrower (the bank) to repay it. There are several ways to calculate interest, though. Simple interest is the most basic and refers to interest earned only on the principal balance of a loan. When it comes to savings accounts, account holders usually earn compound interest.

How Interest Works on a Savings Account

Most banks offer savings accounts with interest that compounds either daily, weekly or monthly, and is paid out once a month. Some banks have accounts with interest that compounds quarterly or annually, but that’s becoming increasingly rare.

Compounding interest is best described as interest on top of interest. You still earn from your initial deposit as you would with simple interest, but now you’ll keep earning based on interest that has already accrued. Basically, the balance that you’re earning interest on is constantly changing over time. So the more often your interest compounds, the quicker your savings will grow.

Use the formula A=P(1+r/n)^nt to calculate the compound interest you’ll earn on your account. It goes as follows:

“P” is the principal deposit you make
“r” is the interest rate
“n” is the number of times your interest compounds per year
“t” is the number of years
“A” is the total balance your account will yield.

Consider this example: if you deposit $1,000 in a savings account with 3% interest on Jan. 1, your end-of-year balance would be $1,031 if your money is compounded daily. On an account with simple interest that only grows based on the principal balance, your balance would be $1,030.

It may seem like a small difference but that adds up significantly over time. Also, ideally your savings account will have more than $1,000 and you’d contribute to it regularly. With each dollar you deposit and every day (or week or month) that passes, you’ll earn even more.

Why Banks Pay Interest on Savings Accounts

A bank provides many benefits to its customers. A bank keeps your savings safe, provides FDIC-backed insurance (typically up to $250,000), makes it easy to access your money when you need it and keeps updated records of your finances. So it may seem like interest is just an added bonus. In reality, though, banks pay interest because you are effectively funding their other products. They use the money in your savings account to offer loans to other customers and make investments. The interest they pay you is a portion of the revenue they wouldn’t have been able to earn without your money. Technically, the bank is borrowing money and you are the lender. They stay in business by charging a slightly higher interest rate for their loans than they pay as interest on your account.

Banks determine the interest rate and compounding frequency associated with your account. In turn, these factors determine how much money you’ll have over time. The interest rate will depend on the financial institution you choose to open an account with and the state of the economy when you open it. Your account balance and credit history, however, will play a role too. Higher balances tend to earn at higher rates. Currently, APYs on online savings accounts can exceed 4%.

How to Choose a Savings Account

Of course, you want to find a savings account with a high interest rate. That isn’t the only aspect you need to compare, though. You should also take a look at the minimum balance requirements; monthly fees; service charges for things like overdrafts, bank transfers and ATMs; special product offerings and the customer rating for each of the accounts and banks you are considering. We have created a list of the best savings accounts on the market today to help you choose.

Tips for Finding the Best Savings Rates

Although you may feel safe working with the largest banks, such as Wells Fargo and Chase, don’t be afraid to check out some of the less conventional options out there. Ally, one of the premier web-based banks on the market, offers some of the top interest rates, but it does not operate any physical branches.
Financial advisors are embedded in the world of personal finance, making them experts in the field. Although their services are typically associated with investing, they often can help with banking, taxes and other areas of financial importance as well. Finding doesn’t have to be hard. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.