How Interest Works on a Savings Account

Compound interest has a snowball effect

Fact checked by Michael LoganReviewed by Caitlin ClarkeFact checked by Michael LoganReviewed by Caitlin Clarke

Interest on a savings account is the amount of money a bank or financial institution pays a depositor for holding their money with the bank. Compound interest is interest calculated on principal and earned interest from previous periods, meaning that your earnings are reinvested and future interest is earned on the higher amount.

Learn more about how interest on a savings account works, including how banks use your savings deposits to fund loans.

Key Takeaways

• Banks state their savings interest rates as an annual percentage yield (APY), which includes compounding.
• Compound interest is interest calculated on principal and earned interest from previous periods.
• Simple interest is only calculated based on principal.  
• Interest compounded over a long enough time period can help your savings grow faster.

Savings account interest rates can help you grow your nest egg. A bank essentially borrows money from their depositors by using the deposited funds to lend money to other customers. In turn, the bank pays the depositor interest for their savings account balance while simultaneously charging their loan customers a higher interest rate than what was paid to their depositors.

If you reinvest the interest you earned on your savings account and the initial amount deposited, you’ll earn even more money in the long term.

Note

Compounding is when you earn interest on your savings plus interest on all of the accumulated interest from previous periods. You can use the concept of compounding interest to build up your savings and create wealth.

Interest on savings accounts is expressed in percentage terms. For example, let’s say you have $1,000 in the bank. The account might earn 1% interest. Unfortunately, most banks pay less than 1% interest on savings accounts due to historically low-interest rates.

Compounding Interest

In performing a straightforward interest calculation, $1,000 that earned 1% interest in one year would yield $1,010 (or .01 x 1,000) at the end of the year. However, that calculation is based on simple interest, paid only on the principal or the deposited funds.

Some investors, such as retirees, might withdraw the earned interest or transfer it to another account. The interest payments act as a form of income. If the interest is withdrawn, the depositor’s account will earn simple interest since no interest would be earned on any past interest.

However, with interest rates being lower, some depositors may opt to leave the interest earned in their savings accounts to earn more interest.

The Power of Compounding Interest

In savings accounts, interest can be compounded, either daily, monthly, or quarterly, and you earn interest on the interest earned up to that point. The more frequently interest is added to your balance, the faster your savings will grow.

Using an example of a $1,000 deposit and applying daily compounding every day, the amount that earns interest grows by another 1/365th of 1%. At the end of the year, the deposit would grow to $1,010.05 versus $1,010 via simple interest.

Of course, an extra $0.05 doesn’t sound like much, but at the end of 10 years, your $1,000 would grow to $1,105.17 with compound interest. The 1% interest rate, compounded daily for 10 years, has added more than 10% to the value of your investment.

Again, the amount earned still might not seem like much, but consider what would happen if you could save $100 a month and add it to the original $1,000 deposit. After one year, you would have earned $16.05 in interest, for a balance of $2,216.05. After 10 years, still adding just $100 a month, you would have earned $725.50, for a total of $13,725.50.

A savings account can keep your assets safe from fluctuations in the stock market and real estate values. It’s essentially an emergency fund that can be used for unexpected expenses such as medical bills or car repairs. The money in a savings account is considered more liquid than money in other accounts like CDs because you can access it quickly.

Keep in mind that savings accounts, while a safe place for your money, tend to offer lower rates of return than investing in assets like stocks or bonds.

How Savings Account Interest Builds Wealth

Compound interest can build wealth over time, even when interest rates are at rock bottom. If you’re considering opening an account, it’s quick and easy to find the current rates banks are offering by going online. Some banks specialize in high-yield savings accounts.

The best savings accounts include those offered by banks where interest on the account is compounded daily, and no monthly fees are charged. Banks often state their interest rates as annual percentage yield (APY), reflecting the effects of compounding.

Important

The APY and annual percentage rate (APR) are not the same. The APR doesn’t include compounding. 

Frequently Asked Questions (FAQs)

What’s Compound Interest Compared With Simple Interest?

Compound is interest on your interest, or reinvesting accumulated interest from previous periods. Simple interest is paid only on the principal or the deposited funds.

What’s the Long-Term Benefit of Compounding?

Investors can use the concept of compounding interest to build up their savings and create wealth. If you reinvest the interest you earned on your savings account and the initial amount deposited, you’ll earn even more money in the long term.

How Often Is Interest Compounded?

Depending on the type of account or product, interest is typically compounded monthly, quarterly, or annually. Interest can also be compounded weekly or daily.

The Bottom Line

Putting your money in a savings account that earns interest can help you build wealth faster while protecting your money. Understanding how interest works on a savings account and how to compare different interest rates can help you choose the best savings account for you. Consider consulting with a professional financial advisor on how to best budget for your financial goals.

Read the original article on Investopedia.