When you open a savings account, your first priority is often creating savings goals and planning for the future. However, treating interest as an afterthought may mean you aren’t receiving the best returns on your money.
Understanding how interest works can help you make a more informed decision about which savings account is best for you, how interest can help you achieve your financial goals and how to find a savings account that will make your money work harder for you.
What is interest on a savings account?
Interest is money a bank or financial institution pays you when you store your money in a savings account. The financial institution pays you a percentage of your account balance and makes regular interest payments — often at the start or end of your statement cycle.
Why do banks pay interest?
Unlike a checking account, placing money into a savings account allows the financial institution to borrow the money temporarily and use it to generate returns. The bank then passes along some of those returns to account owners as interest.
Rest assured that even if the bank has borrowed the money in your savings account, you can access it at any time and make withdrawals according to the terms and conditions specific to your bank and account type.
How do savings account interest rates work?
The interest rate on your savings account helps determine how much interest you’ll actually earn on your savings.
The annual percentage yield (APY) reflects how much interest you’ll actually earn. It takes into account your base interest rate, as well as how often interest compounds: daily, monthly or quarterly.
To better understand the APY on your account, you first need to understand how compound interest works — and how it can help you earn more interest on your account balance.
Compound interest explained
There are two types of interest: simple interest and compound interest.
Simple interest is easy to calculate because it’s simply a percentage of your principal account balance. If an account owner deposits $5,000 in their savings account, for example, and they earn a simple interest rate of 2% annually, they would earn $100 in interest on that amount in the first year.
Compound interest is more complex but allows you to earn more interest over time (this can be daily, monthly, or quarterly). It is calculated based on the account principal balance plus any accumulated interest, also known as “interest on interest.”
Most banks use compound interest rather than simple interest.
This means your interest earnings will accelerate over time, as long as you maintain the balance in your account.
In the example above, if the account owner earns 2% monthly compounding interest, their $5,000 account would $5,101. By year two, they would be generating interest on a balance of $5,101 — the account principal plus the $101 interest already earned. By year 10, they will have earned $1,107 in interest, for a total balance of $6,107. While they earned that same $101 in the beginning that interest began to steadily earn more interest as the years passed.
When you open a savings account, the financial institution will provide details around your interest rate (also called annual percentage yield, or APY), as well as how frequently interest is compounded: daily, monthly or quarterly. The APY on the account will take into consideration compound interest and give you an accurate look at how much interest you’ll actually earn.
However, you can also calculate the APY yourself, as long as you know the interest and compounding frequency.
Compound interest formula
Here is the formula to calculate compound interest:
A = Final amount
P = Initial principal balance
r = Interest rate
n = Number of times interest is applied per time period
t = Number of time periods elapsed
Let's apply this formula to the example above, 2% interest, compounding monthly on a $5,000 balance:
P = 5000 (deposit amount)
r = .02 (the 2% interest rate in decimal form)
n = 12 (months within the time period)
t = 10 (time period elapsed— in years)
Plugging the above information into the formula gives us:
A = 5,000.00(1 + 0.02/12)(12)(10)
The parenthesis go first.
A = 5,000.00(1.0001666667)120
Then, the exponents and multiplication go second and third, leaving the account owner with:
A = $6,107
How often is interest paid on a savings account?
Most savings accounts will pay out interest monthly.
However, there are some accounts, like timed deposit accounts also known as Certificates of Deposit (or CD's) that have a fixed interest rate for a set period of time and won’t pay out interest until that period has elapsed. To learn which type of account suits your needs, be sure to reach out to your financial institution.
Use interest to build your savings
The “interest on interest” nature of compound interest means that your earnings on any money you save will accelerate over time. The best practices below can help your money work harder for you as you save up for your future.
Start saving early. Give your savings more time to generate interest by opening an account early.
Budget for savings goals. Define why you’d like to save — for example, building your emergency fund or saving for retirement — and build these goals into your budget. Budgeting also helps ensure you won’t need to dip into your savings on a regular basis, so the money will remain in your savings accounts and generate interest.
Choose the right savings account for you. Choose an account with a competitive APY to maximize the amount of interest you earn. As you become a more experienced saver, ask your financial institution if they offer higher APY for account owners that maintain higher balances. You may qualify for a savings account with higher rates if you compile all of your savings into one account.
Finding the right savings account may feel intimidating, but First Republic Bank is here to help. Learn more about the personal savings accounts we offer to find one that suits your needs, or contact us for personalized advice.