Understanding Savings Account Interest: How It Works & Rates

How Does Savings Account Interest Work?

Savings Account Interest Overview

Financial institutions pay individual depositors interest on money deposited in savings accounts. They pay interest because you are allowing the financial institution to use your money to make loans to others. Interest rates paid on savings accounts to individual depositors are generally less than interest rates charged to those borrowing money. However, interest rates may vary considerably depending on the type of financial institution where the money is deposited. If you have a large sum to deposit, you may want to consider calling around to find the best interest rates. In addition, the type of savings account where the money is deposited affects the interest earned. Some savings accounts earn simple interest and others earn interest compounded daily.

Simple Interest

Financial institutions pay interest based on a percentage of your savings account balance. The interest is usually calculated and paid to depositors every three months, which is quarterly. You can figure simple interest in a few easy calculations: Savings account balance times the interest rate, divided by four. You divide by four because the interest is paid quarterly, or four times a year. If the interest were paid monthly, you would divide by 12 because there are 12 months in a year. Here is an example of a quarterly interest payment. Say you have $1,000 in a savings account at two percent interest paid quarterly. The equation would be ($1,000 x .02)/4=$5. You would earn $5 in interest after the first quarter. During the second quarter, you would earn interest on $1,005 if you did not deposit or withdraw any money. The equation would be ($1,005 x .02)/4=$5.03, and the new balance in the savings account would be $1010.03. Each quarter the savings account balance would increase as interest is added to the balance.

Interest Compounded Daily

Individuals earn more interest over time from a savings account that compounds interest daily than from a savings account that pays simple interest. The equation to calculate the interest is the almost the same. Use 365 instead of four, because there are 365 days in a year and the interest is compounded daily. To calculate one year of savings account interest you would need to make 365 separate calculations instead of four calculations. Therefore, most people use an interest calculator to figure compound interest (see Resources below). The equation would be ($1,000 x .02)/365=$0.06. You would earn $0.06 in interest after the first day. The second day, you would earn interest on $1000.06 if you did not deposit or withdraw any money. Of course, the difference will be more significant with larger savings account balances. These banks usually pay the interest into the savings account once a month.