How Does Interest Work on Savings Accounts?

• The money in your savings account is like a loan you make to the bank. As with other loans, it earns interest.
• Most banks apply compound interest to your savings account so that your savings earn “interest on interest.”
• Understanding how interest works in your savings account can help you reach your savings goals.

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 determine the best savings account for you for you, and how it can help you achieve your financial goals.

Do savings accounts earn interest?

Yes, they do. 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. Think of it like a loan where you are the lender and your bank is the beneficiary, paying you interest on your deposits.

What is the interest rate on savings accounts?

Member FDIC (Federal Deposit Insurance Corporation) financial institutions like banks (and National Credit Union Administration, or NCUA, insured institutions like credit unions) set their interest rates based on factors like supply and demand and the Federal Reserve rate. The most recent report from the FDIC shows a national average of 0.07% interest rate for savings accounts.

However, interest rates also vary depending on the bank or kind of bank account you choose for your personal finance needs. For example, an online savings account through an online bank will generally offer higher interest rates than a traditional savings account from a brick-and-mortar bank given the lower overhead costs. Additionally, high-yield savings accounts and money market accounts typically offer higher interest rates than traditional savings accounts at the cost of higher minimum balance requirements, fewer transfers and more.

Why do banks pay interest on savings accounts?

Unlike a checking account, banks may "borrow" money placed into a savings account on a temporary basis and use it to generate returns. Then the bank then passes along some of those returns to account owners as interest.

Rest assured that even if the bank has borrowed any amount of money from 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 you earn interest on a savings account?

The interest rate on your savings account helps determine how much interest you’ll actually earn on your savings, also know as the annual percentage yield (APY). Not to be confused with APR, which is the total cost of borrowing money, like with a loan or credit card, APY is the annual rate of return on an investment. Your APY 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.

Simple vs. compound interest for savings accounts

There are two types of interest: simple interest and compound interest.

Simple interest is easy to calculate because it’s merely a percentage of your principal account balance. This can be used as a quick way to estimate the interest you’ll generate on your deposits in a given year. For example, 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, for a total account balance of $5,100.

However, most banks use compound interest rather than simple interest.

Compound interest is more complex but allows you to earn more interest over time (this can be daily, monthly, or quarterly). It’s calculated based on the account principal balance plus any accumulated interest, also known as “interest on interest.” This means your interest earnings will accelerate over time, as long as you maintain the balance in your account.

Using the same initial deposit as the example above, if the account owner earns 2% interest, compounded monthly, their $5,000 account balance would be $5,100.92 after year one. 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 $1,106 in interest, for a total balance of $6,106.

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 CDs) — that have a fixed interest rate for a set period of time and won’t pay out interest until that period has elapsed.

How to calculate interest earned on a savings account

When you open a savings account, the financial institution will provide details around your interest rate, 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 (or you can always use a compound interest calculator).

How to 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.

1. Start saving early. Give your savings a head start to generate interest by opening an account early.
2. Budget for savings goals. Define why you’d like to save — for example, building your emergency fund or saving for retirement — and factor these goals into your budget. Sticking to your budget can also help 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.
3. 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 combine all of your savings into one account. Be sure to read the fine print about minimum balance requirements, monthly fees, overdraft protection and more. After all, interest rates aren’t the only consideration to make when ensuring your savings account works for you.