A savings account is more than just a safe place to store money. Banks need your cash to operate, and they pay interest if you leave money in your account. While most banks have low interest rates, you can get attractive rates if you expand your horizons. Banks use simple or compound interest to determine how much to pay you in interest earnings. These may sound like the same thing, but they can have astonishing differences in your total interest earnings. We will review how interest rates work on a savings account and strategies to maximize your returns.
How Interest Is Calculated On A Savings Account
Bank account holders receive a percentage of their bank account’s balance as interest. Therefore, you can increase your annual interest payments by increasing your account balance or seeking a bank with a higher interest rate. In addition, you can research your way to a higher interest rate, track your expenses to reduce outflow and look for career growth opportunities to increase your income.
Your financial institution uses either simple or compound interest to calculate earnings on the funds in your savings account. We will further explore these interest structures and how their returns differ.
Why Do Banks Pay Interest On Savings Accounts?
Banks and credit unions value their customers, but it’s not the only reason why they pay interest on savings accounts. Interest payments result from what’s referred to as savings interest, which is earned when your financial institution lends the money you deposit into your account to other borrowers through credit cards and loan products. Banks make an ROI with the money people put in their checking accounts, CDs, money market accounts, and other resources. They tap into this money when consumers borrow money to buy a house, car, or other big-ticket purchases.
The banking industry would experience a hiccup if everyone tried withdrawing their money at the same time, but FDIC insurance provides consumers with the confidence that their money is safe. Banks tend to ask for high interest rates on their loans and give savings account holders a small percentage in return.
Many financial institutions have policies that encourage high account balances and discourage low ones. Minimum balance requirements detail how much money you need in your account to avoid monthly fees. While this policy helps you collect more interest, it hurts more than it helps. If you get charged an account maintenance fee, it can take months or years for interest earnings to catch up to the bank’s fee. You should look for financial management solutions that do not have minimum balance requirements.
Simple vs. Compound Interest
The simple interest formula uses the amount of your original deposit to calculate earnings, even if you deposit more over time. To illustrate, if your Annual Percentage Yield ( APY) is two percent and you start with an opening deposit of $2,000, you’ll earn $40 annually. You start at a 2% return, but since no compounding takes place, you will eventually earn less than a 2% return per year after the first year. Here’s how your money will grow over time:
- Opening deposit: $2,000
- Year 1: $2,040 — ($2,000 + $40)) — 2.00% return
- Year 2: $2,080 — ($2,040 + $40) — 1.96% return
- Year 3: $2,120 — ($2,080 + $40) — 1.92% return
- Year 4: $2,160 — ($2,120 + $40) — 1.89% return
Compounding interest works a bit differently, though. The amount you earn is based on your opening balance and earnings over time. Including the interest earnings for future payouts allows your account to grow faster. In our example, both accounts have the same value after the first year and the same rate. However, the compounding rate creates a gap that grows with each passing interval.
- Opening deposit: $2,000
- Year 1: $2,040 — ($2,000 * 1.02) — same return
- Year 2: $2,080.80 — ($2,040 * 1.02) — additional $0.80
- Year 3: $2,122.42 — ($2,080.80 * 1.02) — additional $2.42
- Year 4: $2,164.87 — ($2,122.42 * 1.02) — additional $4.87
The gap between the compounding interest and simple interest accounts will continue to grow each year. It usually makes sense to use a compound interest account unless the simple interest account’s interest rate is much higher.
Daily vs. Monthly Compounding
If your bank or credit union uses daily compounding, it will calculate your interest earnings each day. But if compounding is monthly, you will only receive interest once a month. The rate of compounding impacts how much interest you will receive and your progress toward goals. If the annual percentage rate and principal are the same between accounts, you will earn more interest with daily compounding than monthly compounding. For most people, daily compounding results in small payments that are only a few cents per day, but having those extra cents compounding each day accelerates your wealth quicker than receiving a monthly allotment.
Average Interest Paid On Savings Accounts
Most bank accounts have a low savings rate, roughly 0.06 percent. This rate is not too impressive, and it’s the main reason many people do not care about interest in their savings. However, you can find higher rates at online banks. Higher APYs let you grow your principal balance quicker in a risk-free environment. The average rate may only be 0.06%, but that doesn’t mean you have to abide by the average for your savings.
