Why Do You Need an Emergency Fund?
- Job loss or unemployment
- Medical or dental bills
- Home repairs
It may come as no surprise that a savings account is a good place to store your money. Savvy savers know that savings accounts tend to offer higher interest rates than checking accounts. This means that with a savings account, you’re earning more money with your money. Sign me up, right?
While a savings account sounds like a sweet deal, you may still be wondering: How does savings account interest work? Fair question. It’s one the puzzles many. Yet understanding how interest works on a savings account is an important part of maximizing the earnings on your hard-earned, carefully stashed, cash.
We’ve got just the overview of how interest works on a savings account to get you started:
At its simplest, interest is the cost of borrowing money. Generally, you’ll pay interest to borrow money, and you can collect interest when you lend money.
But who’s going to pay you to borrow your money? For many people, opening a savings account is one of the easiest ways to go about this. When you put money in a savings account, the bank is technically borrowing the money and paying you interest in return.
“The bank determines the rate, although it’s affected by the general level of rates in the economy and whether the bank is trying to attract new deposits,” says Liz Weston, a certified financial planner and columnist at the personal finance website NerdWallet.
The interest rate determines how much money a bank pays you to keep your funds on deposit. However, Michael Griffin, a certified public accountant and finance professor at the University of Massachusetts Dartmouth, says you should use the annual percentage yield (APY) to compare savings accounts and other savings products.
“The simple way to look at the APY—it’s what you will get on your money,” Griffin says. Meaning, you can use the APY to determine how much you’ll actually earn in interest each year because the APY relies on two inputs: the interest rate and how often the interest compounds. Both are important components of how interest works on a savings account because they impact how much money you’ll earn over time. Your savings account interest could compound daily, monthly, quarterly or annually.
Suppose you deposit $5,000 into a savings account, don’t deposit or withdraw any more money and the interest rate doesn’t change. If the account has a 1.00% interest rate and the interest compounds annually—that is, the bank pays you interest on your balance once each year—you’ll earn $50 after the first year. The APY will also be 1.00% in this example because your interest didn’t compound multiple times during the year.
If a bank offers a 1.00% interest rate on a savings account, the rate of compounding could affect the APY and your earnings, although the differences may be minor.
“With interest rates so low,” Griffin says, “there is not a dramatic difference in relative small balances in a savings account because of different compounding scenarios.”
However, your earnings can increase over time, especially when the savings account offers a higher interest rate and APY, and you’re regularly depositing money into your account.
“When returns earn returns, your money can really start to grow,” Weston says. “Here’s an example of how compounding works: If I give you a penny every day and promise to double it, at the end of a month you would have (drumroll) over $10 million.”
You likely won’t come across Weston’s deal in the wild (one can dream, right?). But lucky for savers, many banks offers savings accounts with interest that compounds daily or monthly, rather than annually.
Understanding how interest works on a savings account and comparing the APY offered at several banks are important steps in choosing where to open an account.
Weston says you can often get better returns from an online savings account because online banks don’t have to pay for branches and can pass the savings on to consumers. Online banks therefore “have advantages over traditional banks,” she says, “typically, no minimum account balance requirements or fees.”
Keep an eye out for fees, like those for overdrafts or ATMs, when you’re comparing different savings account options. These could offset your interest earnings or even cost you more than you earn. Other potential expenses include fees for bank checks or outgoing wire transfers.
So, what is interest on a savings account? Now that you’ve seen how interest works on a savings account and know what to look for when comparing accounts, you can put your new knowledge to work. Whether you’re saving for a new car, a vacation or building up your emergency fund, having a savings strategy can help you meet your goals.
Weston says without a minimum deposit requirement, you could use online savings accounts and “set up as many accounts as you like and name them for different goals: vacation, holidays, property taxes and so on.” Separating your funds into different accounts earmarked for specific purposes can make it easier to resist temptations to spend randomly, which can ultimately help you reach your financial goals sooner.
If you want to focus all of your efforts in one place, another option is to have one account where you keep all of your savings. You could then use a spreadsheet to categorize your funds by bills, expenses or financial goals.
These are just two examples. Have a different idea about how to organize your savings? Try it out. As long as you’re progressing toward your goals, and using your newfound understanding of how interest works on a savings account, you’re headed in the right direction.
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