How Does Savings Interest Work?

Savings accounts are the foundation of personal finance. If your income and financial decisions will eventually bring the balance of this account, you can get help from a financial institution. If you choose a bank or credit union that pays interest on your savings account, your money will grow — just by staying put.

How savings accounts work

When you put your money in a savings account, the bank doesn’t keep all that money in a safe deposit box. The bank, on the other hand, invests your money in lending it to other customers. Don’t worry — your money is protected, even if the other customer defaults on the loan, thanks to insurance from the Federal Deposit Insurance Corporation (for banks) or the National Credit Union Administration (for union). Because other customers have to pay interest on the money they borrow from the bank, you will earn interest on the money you deposit.

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When banks charge higher rates for loans, they often offer higher rates to savers. So, when you see interest rates on a mortgage, for example, you’re usually seeing the interest rate, called the annual percentage rate (APY), usually going up the same way.

The APY represents the total amount you earn each year, or your financial institution pays you simple curiosity or compound interest. If you put $20,000 into a savings account that advertises an APY of 2.35 percent, for example, you’ll make $469.41 in profit over the year, just by letting your money go.

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How to calculate simple interest for a savings account

Estimating how much you can earn from simple interest for a savings account is pretty… simple. Take the principal deposit, and multiply it by the interest rate to estimate your annual income. For example, the principal of $5,000 that earns 2% interest per year is as follows:

Simple interest accrues on deposits. So, you won’t earn an extra 2% on the $100 you earn in interest. To earn interest on your satellite, you need to make sure your accounts are consolidated.

How compound interest works

As the interest is compounded, the amount earned continues to grow. Instead of earning interest only on the principal balance, you will earn interest on the compound balance as it grows. Some accounts compound interest daily; others are less frequent, such as weekly, monthly or quarterly. Daily compounding is the most profitable, giving you more opportunities to grow your money.

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For example, a $5,000 deposit that earns 2% interest compounded quarterly will make a profit of $100.76 in the first year. What about accounts that compound daily? The first year is $101 in interest. Another 24 cents may not seem like much, but every penny counts when you’re trying to grow your money. Consider the math of putting $5,000 into an account that earns 2% and compounds interest daily.

$5,000 at a 2% interest rate, compounded daily

Starting balance

Balance after 1 year

Balance after 5 years

Balance after 10 years

$5,000

$5,101

$5,526

$6,107

To really take advantage of the combination, you can increase your balance more actively. Consider this example of a similar account depositing an additional $50 per month.

$5,000 (plus $50 monthly deposit) at 2% interest, compounded daily

Starting balance

Balance after 1 year

Balance after 5 years

Balance after 10 years

$5,000

$5,708

$8,684

$12,755

Long-term benefits of compounding

Financial experts often describe compounding as a snowball. As you roll a snowball over a new layer of snow, it gets bigger and bigger. Compounding interest does the same thing: it keeps growing. Consider an initial $5,000 deposit with 2% interest compounded daily. Over 50 years, that adds up to $8,591 in extra interest — a big snowball.

How to earn more interest on a savings account

If you are looking to increase your income, make sure you put your money in a high-yielding savings account and look for institutions that compound interest daily. Banks with fewer brick-and-mortar branches — or no physical branches at all — have lower fees and often pay higher interest rates.

But you don’t have to put your money in a savings account to take advantage of the interest. APY rates are also increasing for the best money market accounts and certificates of deposit (CDs). Make sure you understand the trade-offs available for each type of account.

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