How does savings interest work?

How does savings interest work?

A savings account is the basis of your personal finances. Although your income and financial decisions ultimately determine the balance in this account, you can seek 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 parked there.

How a savings account works

When you deposit your money in a savings account, the bank does not keep all that money in a safe deposit box. Instead, the bank puts your money to work by lending it to other customers. Don’t worry, your money is protected, even if that other customer doesn’t repay the loan, with insurance from the Federal Deposit Insurance Corporation (for banks) or the National Credit Union Administration (for credit unions). ). As other customers are required to pay interest on the money they borrow from the bank, you will earn interest on your deposited money.

When banks charge higher rates for loans, they usually offer higher rates to savers. So when you see interest rates on mortgages go up, for example, you’ll often see interest rates on savings, called annual percentage yield (APY), generally moving in the same direction.

The APY represents your total annual earnings, whether or not your financial institution pays simple interest Where compound interest. If you deposit $20,000 into a savings account that advertises an APY of 2.35%, for example, you’ll earn $469.41 in interest over the course of the year, just for letting your money stay there.

How to Calculate Simple Interest for a Savings Account

Estimating your potential earnings from the simple interest of a savings account is quite…simple. Take your principal deposit and multiply it by the interest rate to forecast your income for the year. For example, a $5,000 principal that earns 2% interest every year looks like this:

Simple interest accrues on the deposit of money. So you won’t earn an extra 2% on that $100 you earn in interest. To earn interest on your interest, you’ll need to make sure your savings account is compounded.

How Compound Interest Works

When interest is compounded, earnings constantly multiply. Rather than earning interest only on the principal balance, you’ll earn interest on the total balance as it grows. Some accounts earn interest daily; others less frequently, such as weekly, monthly or quarterly. Daily compounding is the most lucrative, providing more opportunities for your money to grow.

For example, a $5,000 deposit that earns 2% interest compounded quarterly would earn $100.76 in interest in the first year. What about a daily compounded account? The first year costs $101 in interest. Another 24 cents may not seem like much, but every penny counts when trying to grow your money. Consider the calculation of depositing $5,000 into an account that earns 2% and compounds interest daily.

$5,000 at 2% interest, compounded daily

Opening 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 compounding, you can increase your balance more proactively. Consider this example of the same account with an additional savings deposit of just $50 per month.

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

Opening 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 capitalization as a snowball. As you roll a snowball through a layer of fresh snow, it gets bigger and bigger. Compound interest works the same way: it constantly increases a little more. Consider that $5,000 initial deposit with 2% interest compounded daily. Over 50 years, that’s $8,591 in additional interest – a pretty big snowball.

How to Earn More Interest on a Savings Account

If you’re looking to boost your income, be sure to deposit your money in a high-yield savings account and look for institutions that accrue interest daily. Banks with fewer physical branches – or no physical branches at all – have lower operating overhead and tend to pay higher interest rates.

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

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