The term "interest" can refer to either the cost of borrowing money through a loan or credit card or the return earned on an investment. When it comes to savings products, such as certificates of deposits (CDs), money market accounts or high-yield savings accounts, we’re talking about the latter. In short: Your savings account interest rate, expressed as a percentage, indicates how much your savings will earn you money.
For instance, let's say you deposit $100 into a savings account with an annual interest rate of 2%. Over the course of 12 months, you'll earn a total of $2 in interest. At the end of the year, your account balance will be $102 — so long as you haven’t made any withdrawals or additional deposits.
Read on to learn how interest rates work on savings accounts, the factors that influence interest rates and how to best maximize your return on investment.
Table of Contents
- What are savings account interest rates?
- How do interest rates work on savings accounts?
- How to calculate interest in a savings account
- What are the best savings interest rates?
- How often does a savings account earn interest?
- How to use interest to increase your savings
- What are the minimum balance requirements to return on the investment?
- How interest rates work on a savings account FAQ
What are savings account interest rates?
Savings account interest rates are the percentage of the deposited amount that earns money from the financial institution holding your funds. You’ll notice that many financial institutions refer to the interest rate as APY, or annual percentage yield.
Banks, credit unions and other financial institutions offer these payouts because the institution benefits from holding your money. Your account funds are used for loans to other customers (e.g. credit cards, mortgages and personal loans), and borrowers pay interest to the financial institution. As a result, some of that money earned by the financial institution is then paid back to you in the form of accrued interest on your savings account.
It’s important to note that the rates offered by banks, credit unions and other financial institutions on any product — loans, credit cards and interest-bearing bank accounts included — are heavily influenced by the federal funds rate set by the Federal Reserve. Generally, when the Fed raises rates, financial institutions follow suit.
The best savings accounts offer high interest rates or APYs as a way of passing along the financial institution’s gains from charging borrowers higher interest rates.
Pros and cons of interest rates on savings accounts
As with any personal finance product, savings account interest rates work mostly to your benefit, but they also have some downsides. The following pros and cons range in complexity from the obvious (higher rates mean higher returns) to more subtle considerations, such as changing interest rates and inflation risk.
When compared with simply leaving your money in a checking account, earning interest on a savings account offers a secure and somewhat consistent return on your money. The FDIC also insures money deposited in your account, up to $250,000 per depositor, meaning your money remains safe in case of bank failure.
When you earn interest on a savings account, the bank will add the money you've earned to your initial deposit, where it continues earning more interest over time. This is known as compounding interest, and it allows you to grow your savings at an accelerated rate.
Unlike more complex investments such as stocks or real estate, savings accounts are highly accessible. This includes low or no minimum balance requirements as well as the ability to easily withdraw or transfer funds a certain number of times per month.
Insulated from market fluctuations
Unlike stocks or other investments, the value of your money in a savings account will remain stable regardless of what happens in the markets. This means you can rest assured that your money is safe and secure from the uncertainty of financial markets.
Low interest rates
The most obvious downside to savings accounts is that the rates of return tend to have lower ceilings than other, more complex investments. While other forms of investments can offer the possibility of exponentially higher returns, they also typically come with significantly greater risks.
Limitations on withdrawals
Previously a federally mandated limit, banks can now set their own restrictions on the number of withdrawals you can make from your savings account each month. Depending on the bank, this could be as few as six times per month, with fees for additional withdrawals above the limit.
Variable interest rates
Savings accounts typically have variable interest rates, which means the amount of return you receive could change over time. These interest rates are heavily tied to the Federal Funds Rate, which the Federal Reserve determines. While the changes in these rates are much more gradual than other investments, such as the stock market, they can still significantly impact your return over time.
How do interest rates work on savings accounts?
Bank interest rates on savings accounts are typically tied to a central bank rate, such as the Federal Funds Rate in the U.S. This rate directly impacts the returns you earn on your savings. It is influenced by various economic factors and can gradually change based on prevailing economic conditions. Banks utilize this rate as a basis for determining their own interest rates on savings accounts, with some banks offering more competitive rates than others.
You can calculate the amount of interest you earn by multiplying the interest rate by the balance of your savings account. Typically, this interest compounds on a daily, monthly, quarterly or annual basis, depending on the bank. This is known as the compounding period.
For example, if you open a savings account today with $10,000 and an interest rate of 1% that’s compounded once per year, you'll earn $100 in interest in your first year.
Simple interest vs. compound interest
The two main types of interest are simple and compound.
Simple interest is calculated based only on the principal amount of money and is typically compounded annually (once per year). This means if you had a principal balance of $10,000 with an interest rate of 5% APY (annual percentage yield), you would earn $500 in interest at the end of the year.
Compound interest is calculated on both the principal amount and the accumulated interest. This accumulated interest can be calculated quarterly, monthly or even daily, depending on the bank. It's typically added to your principal balance once a month. Most savings accounts use compound interest, meaning that you will earn interest on the interest previously earned.
How to calculate interest in a savings account
To calculate the interest rate on your savings, you'll need to know the current annual percentage yield (APY). This rate is typically listed on a bank's website or provided in your account information. Once you have the APY, you can use an online calculator or a formula to calculate the interest rate.
The simple interest formula: Interest = P x R x T
This simple interest formula will help you calculate the amount of interest earned on your principal balance if the interest is compounded once per year. The formula is Interest = P x R x T.
P = Principal amount (the beginning balance)
P stands for the principal amount or the original balance of your savings account. This is the amount you initially deposited into the account.
R = Interest rate (usually per year, expressed as a decimal)
R stands for the interest rate, typically expressed as a decimal representing a year's worth of interest. You can use this annual percentage yield (APY) to compare different accounts.
T = Number of time periods (generally one-year time periods)
T stands for the number of time periods, typically one-year intervals between each compound interest payment.
What are the best savings interest rates?
The best savings account rates are often offered by online banks, because these financial institutions have much lower overhead costs than brick-and-mortar banks. Still, some well-known banks also offer competitive rates.
Among the two main types of savings deposit accounts — traditional savings accounts and high-yield savings accounts — it’s high-yield savings accounts, as the name indicates, that generally have the highest APYs.
As always, the best financial decisions are a result of plenty of research. Evaluate multiple savings accounts in your decision-making process.
How often does a savings account earn interest?
The frequency of interest payments will vary depending on the type of savings account you have and the institution offering it. Most savings accounts earn interest daily and pay out a lump sum of that interest at the end of each month. (If you have an online savings account, check to see if the financial institution provides an interest calculator.)
How to use interest to increase your savings
You don’t necessarily need the help of a financial advisor to learn how to optimize your savings efforts. Firstly, you shouldn't wait to save the perfect amount before opening a savings account. You can always start with a small amount. So long as the institution does not have a minimum balance requirement, you’ll earn interest on however little you deposit.
Establishing automatic transfers into your savings each month will foster discipline and consistency in your effort to save money, earn interest and meet your financial goals. Furthermore, savers can explore the market for the best available rates and transfer funds to accounts offering higher interest rates.
What are the minimum balance requirements to return on the investment?
Generally, the more you add to your savings deposit account, the more you will earn. In terms of a minimum balance requirement to actually see returns on your funds, consider account fees, such as monthly fees or minimum balance fees.
If the financial institution does not charge fees, then you’re set up for continued earning. However, if there are fees associated with your account, be sure to maintain a balance that will exceed the fee each month — otherwise, you won’t see a return on your investment.
How interest rates work on a savings account FAQs
How often do savings account interest rates change?
What is the difference between APY and APR?
What factors should I consider when choosing a savings account?
Factors you should consider when choosing a savings account include the interest rate (the higher the APY, the better) and any fees associated with the account. Additionally, some set minimum deposit requirements, so make sure you get a full picture of the account details before making a decision.
Also, consider how easy it is to transfer money into and out of your savings account; some banks offer more options for transferring funds than others. Lastly, be sure the financial institution is insured by the Federal Deposit Insurance Corporation; check this by looking to the bottom of the institution's page for "Member FDIC."
What are the fees that can affect the overall return on the investment?