How Does Interest Work on a Savings Account?

A savings account is a smart place to store money. It has higher interest rates than checking accounts, helping you earn more without sacrificing liquidity. And, although they yield lower returns than most other investments, they have less risk. However, many investors still wonder, how does interest work on a savings account? Understanding this key element of your savings account is important to help you make the most of your earnings. A financial advisor can offer valuable insights into managing your money.

Interest Explained

Interest is essentially the amount of money paid in exchange for borrowing someone else’s money. This accounts for the risk of lending money while providing an incentive for lending.

Interest is generally calculated as an annual percentage of a loan or balance and paid to the lender at agreed-upon rates. Interest can also be based on longer or shorter terms. Interest amounts are usually determined by the original amount of the loan, the interest rate and the length of time it takes you or your borrower (the bank) to repay it.

The concept of an annual percentage rate (APR) may be familiar from your monthly credit card statements or student loan paperwork. That is interest you pay as the borrower, in addition to the principal amount of the loan.

Annual percentage yield (APY), on the other hand, is the interest you earn for lending your money. It conveys your rate of return for the year. In addition to helping you grow wealth, APY can encourage better savings behavior.There are several ways to calculate interest. Simple interest is the most basic and refers to interest earned only on the principal balance of a loan. When it comes to savings accounts, account holders usually earn compound interest.

How Interest Works on a Savings Account

Coins in stacks from lowest to tallest, showing how savings grow with interest.

Most banks offer savings accounts with interest that compounds either daily, weekly or monthly and is paid out once a month. Some banks have accounts with interest that compounds quarterly or annually, but that is becoming increasingly rare.

Compounding interest is best described as interest on top of interest. You still earn from your initial deposit as you would with simple interest, but you also earn on interest that has already accrued. Basically, the balance on which you are earning interest is constantly changing over time. The more often your interest compounds, the quicker your savings will grow.

Use the formula A=P(1+r/n)^nt to calculate the compound interest you’ll earn on your account. It goes as follows:

“P” is the principal deposit you make
“r” is the interest rate
“n” is the number of times your interest compounds per year
“t” is the number of years
“A” is the total balance your account will yield.

Consider this example: if you deposit $1,000 in a savings account with 3% interest on Jan. 1, your end-of-year balance would be $1,031 if your money is compounded daily. On an account with simple interest that only grows based on the principal balance, your balance would be $1,030.

It may seem like a small difference but that adds up significantly over time. Also, ideally your savings account will have more than $1,000 and you’d contribute to it regularly. With each dollar you deposit and every day (or week or month) that passes, you’ll earn even more.

Why Banks Pay Interest on Savings Accounts

A bank provides many benefits to its customers. It keeps your savings safe, provides FDIC-backed insurance, allows for easy access to your money when you need it and keeps updated records of your finances.

Therefore, interest may seem like just an added bonus. In reality, though, banks pay interest because you are effectively funding their other products. They use the money in your savings account to offer loans to other customers and make investments. The interest they pay you is a portion of the revenue they would not have been able to earn without your money.

Technically, the bank is borrowing money, and you are the lender. They stay in business by charging a slightly higher interest rate for their loans than they pay in interest on your account.

Banks determine the interest rate and compounding frequency associated with your account. In turn, these factors determine how much money you will have over time. The interest rate will depend on the bank or credit union you choose to open an account with and the state of the economy when you open it.

Your account balance and credit history, however, will play a role, too. Higher balances tend to earn at higher rates with savings account rates currently exceeding 4 percent.

How to Choose a Savings Account

A woman meeting with a financial advisor to discuss a financial plan.

When comparing the best savings accounts, interest rate is one of the first features to consider. A higher annual percentage yield (APY) means your money will grow faster. However, it is important to know if the rate is variable or fixed and whether it applies to all balances or only above a certain threshold. Some banks also promote short-term introductory rates that later drop, so read the terms carefully.

Be sure to check for bank fees and minimum balance requirements. Some accounts charge monthly maintenance fees unless you maintain a minimum balance. Other possible charges include ATM fees, overdraft fees and limits on how many withdrawals you can make each month. These costs can cut into your interest earnings, so consider whether the account terms fit your savings habits.

Finally, think about convenience and service. If you like online banking, look for an account with a strong mobile app and digital banking tools. If you prefer face-to-face help, choose a bank with physical branches nearby. Other features—such as automatic transfers, alerts or budgeting tools—can also support your savings goals and make account management easier.

How to Maximize Your Interest Earnings

To increase the amount of interest you earn on your account, start by comparing savings rates across different banks. Online banks often offer higher annual percentage yields (APYs) than traditional brick-and-mortar banks. Before opening an account, check for tiered interest structures, as some banks reward higher balances with better rates. Also, avoid accounts that charge monthly maintenance fees, as these can offset any interest earned.

Another factor to consider is compounding frequency. The more often interest compounds—daily instead of monthly—the more you will earn over time. Even small differences in compounding schedules can make a noticeable impact, especially as your balance grows. Choose accounts that compound interest frequently and pay out at least monthly so you can take full advantage of the compounding effect.

Finally, increase your balance steadily by setting up recurring deposits. Automating transfers from a checking account to your savings ensures consistent growth. The larger your balance, the more interest you earn, so consistent contributions help accelerate that growth. This strategy works well for both short-term savings goals and building an emergency fund over time.

Bottom Line

Earning interest on a savings account depends on the rate, compounding method and your balance. Accounts with higher APYs and frequent compounding generally earn more. To make the most of your savings account, be sure to compare rates, avoid fees and deposit money regularly to grow your balance over time.

Tips for Finding the Best Savings Rates

Although you may feel safe working with the largest banks, such as Wells Fargo and Chase, don’t be afraid to check out some of the less conventional options out there. Ally, one of the premier web-based banks on the market, offers some of the top interest rates, but it does not operate any physical branches.
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