How does interest work on a savings account?

If you are new to saving, you might be wondering: how does interest work on a savings account? Savings account interest rates can help grow your money. But how does bank interest work, and what is interest on a savings account? Understanding what interest is can help you make a more well-informed decision when choosing a savings account.

Interest is the cost of borrowing money, or the return earned on savings and investments. When you save money in a savings account, you earn interest on your deposit. When you borrow money, you pay interest to the lender. Interest rates are the amount lenders charge to borrow money or any sort of asset.

Interest is one of the greatest influences on our financial system, and within the economy. It essentially affects the cost of almost anything we purchase, above all big expenses such as cars and property. The Federal Reserve, also known as the Fed, is the central bank of the United States, which is in charge of maintaining a stable financial system within the country. The Fed oversees the federal funds rate, which is the  interest rate at which banks lend to each other overnight. This rate determines the price of borrowing money.

We now have a better understanding about interest and its importance on the economy, but how does interest work on a savings account?

A savings account interest rate is the percentage a bank pays you on the funds you deposited. Basically, when you put money in a savings account, the bank can “borrow” it and pay you interest in return. Savings interest rates determine how much your money will grow over time. Average savings interest may vary by bank, account type, and type of interest.

There are many factors that can affect the rate of interest earned on your savings. To break things down, let's look at simple and compound interest, and annual percentage yield.

Simple interest is a type of interest that banks pay customers on their savings accounts. It is earned only on your principal amount. For example, if you initially deposit $1,000 in your savings, the simple interest would be calculated on this amount. If you want to calculate how much simple interest you would earn over a given number of years, you can use the following formula:

Where:

• P = principal amount (Your initial
• R = annual
• T = time in years

Following the example from above, this is how you would calculate simple interest, if you took the initial deposit of $1,000, with an annual interest rate of 5% over a period of five years.

You would earn $250 worth of simple interest over five years. Assuming you don’t withdraw or deposit money in your account during this time and the annual interest rate doesn’t change, you would have a total of $1,250 in your savings account. Simple interest does not apply to interest payments you have already received, so during those five years, you would only be earning interest on the initial amount.

Compound interest, on the other hand, allows you to earn interest not only on your initial deposit, but also on the interest accumulated over time — so interest would be paid on both the principal and existing interest. Compound interest is calculated on an annual, semi-annual, quarterly, monthly, or even daily basis.

Calculating the compound interest based on annual compounding can be done by using the following formula:

Where:

• P = Principal amount (Your initial
• R = Annual
• t = time in years 

Using the same example, the interest used on the initial $1,000 deposit in the first year would remain the same. However, in subsequent years, the interest would be calculated on the growing balance — including both the original deposit and interest earned in the previous years. This means that with a 5% interest rate, each year’s earnings would be slightly higher than the last. To calculate the compound interest on this example over a period of five years, with an annual interest rate of 5%, and based on annual compounding would look something like this: 

Meaning, you would have earned $276.28 in compounded interest over five years, totaling to $1,276.28 in your savings. 

Over time, compound interest can significantly increase your savings, especially if you leave your money untouched over an extended period of time. Savings accounts usually earn compound interest, however, it is important to understand the way both types of interest work. If you want to get an estimate of how much interest you can earn over time, you can also use helpful tools like online savings account calculators. 

Note: The interest values in these examples are for illustrative purposes only and may not reflect actual rates. Interest rates vary by bank, account type, and market conditions. Please check with your financial institution for current rates and terms.

Annual percentage yield (APY) and interest are often used interchangeably, but they are distinct concepts. APY represents the total amount you can earn on your savings over one year, expressed as a percentage, and also accounts for compounding. While interest is a component of APY, the key difference is that APY factors in how frequently interest is compounded, giving you a more accurate picture of your potential earnings.

Because APY reflects the impact of compounding, banks and other financial institutions typically highlight it over the basic interest rate. This may help consumers better understand and compare their long-term earning potential. The frequency of compounding also plays a crucial role in how much your savings can grow, but we will further explore this topic in the following section.

In short, interest rates indicate the basic rates at which your money will accrue interest, while APY provides a clearer picture of your total earnings over a year by incorporating the effects of compounding.

There are several factors that can influence how often your savings earn interest. This includes interest rates, compounding frequency, variability, the timing of deposit and withdrawals, and changes in interest rates. Compounding frequency and interest rate fluctuations play a key role in determining how your savings may grow over time.

Compounding frequency determines how often interest is calculated and added to your savings. In general, most savings accounts compound interest daily or monthly, but this can also happen quarterly or annually. The more frequently interest is compounded, the faster your savings can grow, given you are earning interest on both your initial deposit and accumulated interest.

Raisin, for example, offers access to savings products with daily compound interest. However, the amount of money you deposit, how long you leave your money in your savings, and the interest rate on your account will also affect the rate at which your account will grow. 

Interest rates may be either fixed or variable. As the name suggests, fixed rates remain constant for a set period, offering predictable returns. Fixed rates are commonly used for Certificates of Deposit, (CD), accounts. CDs set predetermined interest rates, which typically remain constant during the account term. 

Variable rates, on the other hand, fluctuate based on market conditions and financial institution policies. Such rates are often used for savings accounts. Some accounts may even offer promotional rates, which can change after an initial period of time.

It is important to know whether your interest rate is fixed or variable, as this can help you estimate potential earnings, and which account is best for you. Understanding these factors can help you make more informed decisions about where to keep your money. Checking specific account terms, and exploring different account types can help maximize your savings potential.

Although traditional savings accounts are very common savings methods, they don’t typically offer the best interest rates. Online savings accounts have become more popular, and tend to offer more competitive interest rates.

Here are some options you can consider to help boost your earnings:

• High-yield savings accounts: High-yield savings accounts are specialized savings accounts that provide higher interest rates than traditional savings accounts. They are usually offered by online-only banks, with little to no fees, and generally do not require a minimum balance. High-yield savings accounts may give you the opportunity to grow your money faster than traditional savings accounts, due to the higher interest rates.

• Fixed-term certificates of deposit (CDs): Fixed term CDs, or traditional CDs, can be useful for saving for relatively distant goals. CDs are fixed-term deposits, where a lump sum of money is typically deposited for a specified time period. These accounts can help you lock in higher APY and interest rate offers than traditional savings accounts, and can help you earn more on your savings. Fixed terms can range from a few months to several years, but you may be charged penalty fees if you withdraw your money before the end of the term. 

• No-penalty CDs: No-penalty CDs function the same way as traditional CDs, but as the name suggests, you are able to withdraw money, without paying a penalty. Since these are more flexible than traditional CDs, they usually have lower interest rates than their counterpart. Find out more about how no-penalty CDs work.

• Money market accounts: Money market accounts can be very similar to high-yield savings accounts. They combine the convenience of a traditional savings account, but often offer higher interest rates and APYs. Some financial institutions may have higher minimum balance requirements on money market accounts, and may set withdrawal limits. However, money market accounts offered through Raisin only require a $1 minimum deposit and do not have withdrawal limits. 

High-interest savings accounts can help you reach your savings goals and grow your wealth. When considering what account best fits your needs, you may want to look at interest rates, APYs, fees, withdrawal limits, and minimum balance requirements.

Accounts with higher interest rates can help your savings grow faster, but it is also important to keep an eye on inflation. If your savings don’t earn enough interest to outpace inflation, this may negatively affect your money over time. Therefore, it is recommended to learn more about how to choose a bank, to see which one could offer you the most competitive rates. 

Our marketplace at Raisin offers a wide range of high-interest savings accounts, making it easier to find a savings account that fits your needs. Explore high-interest accounts with Raisin and start maximizing your savings today.

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.