How interest works on a savings account

What is interest on a savings account? 

Interest is money that a bank, credit union, or other financial institution pays you for parking your cash in a savings account. The amount you receive is based on the size of your balance, the interest rate, and how often that interest compounds. The interest you can expect to earn on a savings account over one year is expressed in terms of an annual percentage yield (APY).

Not all savings accounts work the same way, nor do they offer the same interest rates. For example, traditional savings accounts offered by big banks will usually have much lower rates than online high-yield savings accounts. So if you’re concerned about getting the best APY, it’s important to compare rates across many financial institutions before opening a savings account. 

Why do banks pay interest?

Financial institutions rely on customer deposits to fund loans and investments, which generate revenue. So they pay interest to entice you to keep your money in your savings account.

“You’re essentially loaning money to the bank, and the bank is paying you an interest rate for that loan,” says Anderson Lafontant, a certified financial planner with Miracle Mile Advisors. She adds that if you need to pull your money out, you can. “But a deposit account with a bank is essentially on the bank’s balance sheet, and they’re using those funds to go make other investments.”

Simple interest vs. compound interest 

Simple interest means the interest rate is applied only to the principal balance in your savings account. It’s usually calculated annually. Here’s the formula:

Simple interest = Principal x Interest rate x Time period

Say you have $1,000 in a savings account with a simple interest rate of 2.00% APY. Using the formula, here’s how much you’d earn: 1,000 x 0.02 x 1 = 20. That means you’d earn $20 in a year, leaving you with a new balance of $1,020.

With compound interest, the interest rate is applied to the principal balance and accumulated interest, which can be calculated daily, monthly, quarterly, etc., and is typically deposited into your account each statement period. 

Most types of savings accounts use compound interest, and the formula is a bit more complex:

A = P(1 + r/n)^nt

• A: accrued amount (principal + interest)
• P: principal
• r: rate
• n: number of compounding periods per unit of time
• t: time in decimal years (for example, 6 months would be 0.5 years)

Let’s take our example from before, except instead of using simple interest, the savings account rate compounds monthly. So every month, your interest earnings are added to the balance and begin earning interest the following month—a snowball effect. At the end of one year, you’d earn $2.18 instead of only $2. That might not seem like a big difference. But with larger balances over longer time periods, the earnings can really add up.

“We like to say there’s a power of compounding, which is why it is so important to start saving early on,” Lafontant says. “Over time, the beauty of compounding can make savings just that much more lucrative.” That’s because your earnings also generate interest, not just the principal balance.

In other words, compounding interest increases an account’s value faster than simple interest, according to Lisa Featherngill, national director of wealth planning at Comerica Bank. “For the fastest increase, you want frequent compounding and the interest added to the account balance (rather than paid to the individual).”

Types of savings accounts with compound interest

If you’re looking for a place to put your savings, you have a few options that earn compound interest.

• Traditional savings account: This can be found at almost any bank. (At credit unions, savings accounts may be referred to as “share” accounts.) Most savings accounts compound interest at least once per year, though the rates can vary widely.
• High-yield savings account: This type of savings account offers higher interest rates than those typically available for traditional savings accounts. You may need to meet certain requirements to obtain the higher APY, but many high-yield accounts exist without any restrictions or fees, especially among online banks and credit unions.
• Certificate of deposit (CD): A CD is a type of savings account that pays a certain amount of interest for keeping your money on deposit for a set period of time. Usually, the longer the term, the higher the rate. However, if you pull your money out before the CD matures, you’ll have to pay an early withdrawal penalty.
• Money market account (MMA): Not to be confused with money market funds, money market accounts work like checking-savings hybrids. They typically pay higher rates than traditional savings accounts, but also usually require a higher minimum balance and may come with monthly maintenance fees. 

Whichever type of account you choose, be sure it’s insured by the Federal Deposit Insurance Corporation (FDIC). This means your deposits are protected up to $250,000 if the bank fails.

How to maximize interest on your savings

When shopping around for a new savings account, Featherngill says it’s important to compare interest rates and terms before making a decision. Don’t be enticed by the first offer you see, as another bank may be offering a higher rate or lower fees. 

It’s also important to pick the right type of account based on your financial situation and specific needs. For example, Featherngill says, a CD might pay a higher rate, but has limitations on access to the funds prior to maturity. So despite the high APY, a CD might not be the best option for someone who needs their savings to be easily accessible and liquid.

The takeaway

Understanding how interest works on savings accounts can help you make informed decisions about where to put your cash and how to make it work for you. That’s especially important given today’s economy.  

“The interest rate environment has been changing rapidly, especially as the Federal Reserve has raised rates,” Featherngill says. “[Savings accounts] vary amongst financial institutions, so understanding the products, the true interest you may receive (including the effect of compounding), and any restrictions on accessing the funds is important.” 

Use this period of high interest rates to your advantage and consider opening a high-interest savings account that can help build your wealth faster. “Especially now, when some high-yield savings accounts are getting three, four—probably close to five percent soon, keeping your money in those high yield savings accounts and continuing to earn interest on your interest is just going to set you up for those savings to continue to grow,” Lafontant says.