How Interest Works on a Savings Account

Understanding how interest works on a savings account is essential for anyone looking to grow their money over time. Savings accounts are one of the safest and most accessible ways to do so. When I first started learning about savings accounts, I was overwhelmed by terms like “compound interest,” “annual percentage yield,” and “interest rates.” But once I broke everything down, it all began to make sense. Now, I’m going to walk you through it, using simple explanations so that you can understand how interest works on a savings account, too.

By the end of this guide, you’ll know how your money can work for you without requiring much effort beyond opening the account.

What is Interest?

Interest is essentially the amount of money a bank pays you for keeping your money in their savings account. Think of it as a reward. When you deposit money into a savings account, the bank takes that money and uses it to issue loans or invest. In return, they pay you a percentage of your balance as interest.

The amount of interest you earn depends on the interest rate, the frequency of interest payments, and how long your money stays in the account. I’ll break these concepts down so you can see exactly how they all fit together.

Interest Rate

When you open a savings account, you’ll notice that the bank advertises a certain percentage as the “interest rate” on your account. This is the annual percentage the bank will pay you for keeping your money there. For example, if you have $1,000 in your savings account and the interest rate is 1%, you’ll earn $10 in interest per year.

However, things get a little more complex when we consider compound interest, which I’ll explain next.

Simple vs. Compound Interest

There are two types of interest that can apply to a savings account: simple interest and compound interest. Compound interest is more common in most savings accounts today, but it’s important to understand both.

Simple Interest

Simple interest is when the bank pays you interest only on your initial deposit (also known as your principal). Let’s say you deposit $1,000 in a savings account with a 1% annual interest rate. After one year, you’d earn $10 in interest. In the second year, you’d earn another $10, and so on. The interest stays the same because it’s only calculated based on the initial $1,000.

Compound Interest

Most savings accounts offer compound interest, which is where things get more interesting. With compound interest, you earn interest not just on your principal, but also on the interest that accumulates over time. It’s like earning interest on your interest.

Here’s how it works. Let’s say you deposit $1,000 in a savings account with a 1% annual interest rate that compounds monthly. After one month, you’ll earn a small amount of interest, which gets added to your balance. In the second month, the bank calculates interest on your new balance (which now includes your initial deposit plus the first month’s interest). Over time, this process repeats, allowing your money to grow more quickly.

In the case of our $1,000 deposit, after one year, you’d earn slightly more than $10 due to compounding, because each month’s interest is calculated on a slightly larger balance.

How Often Does Interest Compound?

The frequency of compounding can significantly affect how much interest you earn. Most banks compound interest daily, monthly, or quarterly. The more frequently the interest compounds, the more you’ll earn.

For example:

Daily Compounding: Interest is calculated and added to your account every day. This is the most beneficial for you, as you’re earning interest on your growing balance every single day.
Monthly Compounding: Interest is calculated and added to your account every month.
Quarterly Compounding: Interest is calculated and added to your account every three months.

When I first understood the power of compounding, I realized that accounts with daily compounding tend to offer the best long-term growth, even if the interest rate looks small at first glance.

Annual Percentage Yield (APY)

You’ll often see banks advertise an Annual Percentage Yield (APY) alongside the interest rate. APY takes into account both the interest rate and the compounding frequency. It represents the actual amount of interest you’ll earn in a year, considering the compounding effects.

For example, if a savings account has an interest rate of 1%, but it compounds monthly, the APY might be slightly higher, say 1.01%. APY gives you a clearer picture of how much your savings will grow in one year.

If I were opening a new savings account today, I would focus on the APY rather than the interest rate because it’s a more accurate representation of how much money I’ll make.

See; What Is APY and How Is It Calculated?

Conclusion

Understanding how interest works on a savings account is crucial for growing your money over time. By choosing the right account, you can take advantage of compound interest, maximize your earnings, and achieve your financial goals. Now that you know how interest works, you’re in a better position to make informed decisions about your savings strategy.

Whether you’re just starting or have been saving for a while, keep in mind that every little bit of interest adds up. The more consistent and patient you are, the more your money will grow. Let your savings account work for you while you focus on other aspects of your financial life.

How Interest Works on a Savings Account