What is interest? A complete guide to how your money earns and grows
Whenever you log into your account online and notice that your savings account has grown, you’re seeing interest at work. Interest is the money your bank or credit union pays you for keeping your money on deposit. While you can pay interest on credit cards or loans, our focus here is on the interest you earn on deposits.
Earning interest on your money can be a powerful way to grow your savings. In this guide, we’ll discuss how interest works, the difference between annual percentage yield (APY) and interest rate, and compound versus simple interest to help you understand how your savings can grow.
What is interest in simple terms?
Interest is the money a bank pays you for depositing money in an account. You may not realize this, but when you deposit money at a bank, you’re providing funds the bank can use to make loans to other individuals or businesses. In essence, the financial institution compensates you for allowing it to use those funds for lending and other activities.
The bank charges interest on those loans and pays you interest on your savings. The difference between what the bank earns and what it pays depositors helps the bank operate profitably. Paying interest also helps banks attract and retain the deposits they need to support their lending activities.
As a consumer, you can be on both sides of the interest equation. You can either earn interest on your savings balances or pay interest on your credit card or loan balances. The former helps increase your net worth while the latter erodes wealth. We’re focusing on the savings aspect in this article.
Interest is generally communicated as a percentage. A higher rate means you earn more on your balance, assuming all other account terms are equal. Thanks to compound interest, small rate differences can add up over time, so it’s important to compare your options carefully.
How does interest work on a savings account?
Knowing how interest works is helpful, but understanding how and why it shows up in a savings account is equally important. Savings account interest earnings depend on the balance, the interest rate, how often the bank credits interest, and the compounding schedule.
The payment process
Financial institutions calculate interest based on your account balance, interest rate, and compounding method. Many savings accounts accrue interest daily but credit it to the account monthly, although practices vary by institution.
When the bank adds interest, it becomes a part of your principal balance. This is important as the added interest earns interest as your account balance grows.
Let’s say you open a savings account with $1,000, and it earns $3 in the first month. The following month, you will earn interest on a balance of $1,003, and that interest will compound over time as you deposit more and earn more interest. Keep in mind that account fees can quietly offset or erase your earnings.
How are interest rates determined?
Several key factors influence the interest you earn on a savings account. Forces that affect savings interest rates include:
- Economic conditions: A robust economy may contribute to higher rates, while a downturn may result in lower rates.
- Federal Reserve policy: Federal Reserve changes often influence savings account rates, although banks decide how much of those changes to pass along to customers.
- Bank type: Brick-and-mortar banks often have higher overheads, which may lead to lower rates. Online banks don’t have that same overhead, and they’re often able to pay more.
- Competition: Banks compete for deposits, and when they need more funding, they may offer higher rates to attract customers.
- Account type and balance: Some savings accounts offer the same rate regardless of balance, but others offer better rates based on your balance or account type.
Interest rate vs. APY: Understanding the critical difference
Understanding interest rates is important, but you may see another term when comparing savings accounts. Financial institutions also use annual percentage yield (APY) when marketing savings accounts. Knowing how the two work is vital to grasping what your savings will earn.
What is an interest rate?
The interest rate is the base percentage a bank uses to determine earnings. It doesn’t account for compounding and may not reflect the full earnings picture.
For instance, if you have a savings account paying a 3% interest rate and you start with $1,000, you would earn $30 over the year using a simple-interest calculation. While helpful to know, that is not a complete picture because it doesn’t consider compounding.
Banks may compound interest daily, monthly, or on another schedule. When the bank compounds your interest, your interest begins to earn interest.
Identifying the interest rate on a savings account is helpful, but knowing the APY paints a fuller picture.
What is an APY?
APY is the effective annual rate a savings account can earn in one year, after accounting for compounding. When you compare savings accounts, you will notice that the APY is typically higher than the stated interest rate when interest compounds more than once a year.
The more frequently the interest compounds, the greater the difference may become. If a bank compounds interest daily, there’s more opportunity for the interest to earn interest than with a bank that compounds interest monthly. The larger your balance, the more of a difference you may notice.
You can calculate APY using this formula:
APY = (1 + r/n)^n – 1
r = the interest rate expressed as a decimal
n = the number of compounding periods per year
Regardless of the savings vehicle you’re considering, whether it is a savings account, CD, or money market account, it’s beneficial to know the APY and not just the interest rate.
Real calculation example
Calculating 5% interest on $5,000 illustrates the difference between simple interest and monthly compounding.
Using simple interest, $5,000 x .05 = $250 at year’s end. The year-end balance would be $5,250.
Running the APY calculation shows that monthly compounding yields a higher balance by year’s end.
At a 5% interest rate compounded monthly, the APY is roughly 5.12%. The result is $255.81 in interest, or $5,255.81 after a year.
The difference may seem insignificant, especially when you’re first starting with a lower balance. However, over time and with larger balances, the difference can become greater.
Ultimately, it’s best to compare savings accounts based on APY. A savings account with a 4.00% interest rate, compounded monthly, has an APY of about 4.07%. On the other hand, a savings account with an interest rate of 4.05% remains at a 4.05% APY.
You can use a compound interest calculator to see how compounding might help you grow your savings.
Interest vs. alternative income options: Making smart choices
Interest-bearing accounts have their place, and they can be a powerful tool for managing your personal finances. Relying on them alone may not provide enough growth for every long-term financial goal.
When interest-bearing accounts excel
Savings accounts are a worthwhile component of a well-rounded financial plan. Key benefits of savings accounts include:
- Safety: Eligible deposits are generally protected up to applicable insurance limits. The Federal Deposit Insurance Corp. (FDIC) insures deposits at covered banks, while the National Credit Union Administration (NCUA) provides similar protection at federally insured credit unions.
- Liquidity: Savings accounts are liquid; even if you have funds at an outside online bank, you can often receive transferred funds within a few business days. Money market accounts provide similar liquidity.
- Predictability: There’s little guessing about what interest you will receive, although savings account rates are typically variable. You can calculate what you may earn based on the current rate, but the bank can change it over time.
- Simplicity: Savings accounts are straightforward. Investment knowledge isn’t necessary.
- Peace of mind: Savings accounts are stable, and that can be a good thing. You can sleep well at night knowing that you won’t lose the principal.
Comparing to alternative income strategies
Interest-bearing accounts are typically an important part of your personal finance toolbox. Using them for emergency funds is wise, but interest-bearing accounts aren’t the only way to generate income or pursue long-term growth.
Stock dividends
Earning dividends from stocks is an impactful way to produce cash flow, especially in retirement. The best high-yield savings accounts are currently paying up to 4%. Depending on the stock, you may be able to earn a higher dividend yield plus the potential of capital appreciation.
Investing in dividend-paying stocks isn’t as straightforward as savings accounts, though. Research is necessary to identify the right investment, and there’s a risk of principal loss.
Bonds
Bonds can create relatively predictable income. Corporate or municipal bonds may pay higher interest rates than some deposit accounts, although yields vary with market conditions and risk.
Treasury bonds are generally exempt from state and local taxes. Municipal bonds often extend federal, state, and local tax exemptions, which can be helpful for high-net-worth individuals.
Bonds are liquid and can be sold before maturity, but they’re not without risk. They aren’t FDIC-insured, and when interest rates rise, bond prices typically fall.
Real estate investment trusts (REITs)
Many REITs trade on the stock market, offering exposure to real estate without the need for property management. Some REITs pay relatively high dividend yields. Depending on your situation, REITs can be a useful tool in a portfolio to create income.
REITs have no FDIC protection, and real estate is sensitive to interest rates. Additionally, you risk principal loss when investing in REITs.
The bottom line: How does interest work?
Interest is money a bank or credit union pays depositors for keeping funds in a savings account or other savings vehicle. The amount you earn depends on the interest rate, your balance, time, and compounding frequency. An interest rate does not account for compounding, while APY reflects its effect. Comparing two accounts based on APY is generally the best approach.
Compound interest can be a powerful tool to build wealth, particularly when you leave money deposited over time. High-yield savings accounts are valuable for building emergency savings, while investments may be more appropriate for some long-term goals.
