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How Does Interest Work on a Savings Account?

How Does Interest Work on a Savings Account?
Austin Kilham
Austin KilhamUpdated February 2, 2023
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
It’s no secret that a savings account can be a smart place to store your extra cash. These accounts keep your money safe, while also paying interest. What’s somewhat of a mystery to many is exactly how interest on savings works. What does 2.00% interest or 2.50% APY really mean? How much will your money actually earn in a month? Or, in a year?What follows is a beginner’s guide to interest on savings accounts, from how it’s calculated to how to get a solid return on your money just by letting it sit in the bank

What Is Interest on a Savings Account?

Savings account interest is a percentage of your account balance paid to you periodically by the financial institution. Defined more broadly, interest is the cost of borrowing money – you pay interest to borrow money and you earn interest when you lend money. What does that have to do with a savings account? When you open a savings account and make a deposit, the bank is technically borrowing that money and paying you interest in return for the loan you are providing. They then use that money to make loans and investments of their own.

How Does Savings Account Interest Work? 

You may have heard the term annual percentage rate (APR) in relation to your credit card. That’s the interest you pay on any balance you carry as a borrower. Annual percentage yield (APY) is the opposite – it’s the money you earn for lending your money to the bank. The APY on a savings account indicates your rate of return for a year. If the APY on your account is 3.00% and you have $3,000 in the account, for example, you’ll earn $90 in a year. Recommended: How Much Does the Average American Have in Savings? 

Why Do Banks Pay Interest on Savings Accounts?

When you open a savings account, you are entering a relationship with a bank or credit union that is mutually beneficial. The money you deposit into your account is safe. The Federal Deposit Insurance Corporation (FDIC) insures bank accounts up to $250,000 per account, per account holder, per ownership category. The National Credit Union Administration (NCUA) provides similar coverage to credit unions. In addition, your money earns interest. The bank or credit union benefits, too. They can now lend your money to borrowers in the form of loans, mortgages, or credit cards. Those borrowers pay the bank interest on those loans at a rate that is generally higher than what the bank is paying you, thus they make a profit.

What Is Considered a High-Interest Savings Account?

A high-interest, or high-yield savings account, is a savings account that offers an APY that is 15 to 20 times higher than the APY on a typical savings account. These accounts are generally offered by online banks, which tend to have lower overhead costs than brick-and-mortar banks, and pass that savings on to their customers in the form of higher APYs and low or no monthly fees.High-yield savings accounts at online banks work in the same way as traditional savings accounts. You can typically access your money via fee-free ATMs and transfer your money online (or through the bank’s mobile app) to your checking account, even if it’s at another bank. If the online bank is insured by the FDIC, you can’t lose your money (up to $250,000), even if the bank were to go out of business.Recommended: What Is a Cash Management Account (CMA)?

Tips for Using a High-Interest Savings Account to Your Advantage

A high-interest savings account can be the ideal place to stow your emergency fund (three- to six-month’s worth of living expenses) and any cash you’re saving for goals or needs that are within a year or two. If you were to let these funds sit in your checking account, they would earn very little or no interest. A higher yield on your money can really help you when saving up for a large purchase or an upcoming event like a vacation.For long-term savings goals, like retirement or a child’s college education, however, it can make more sense to invest your money in stocks or mutual funds. Investments generally have the potential for a higher return than a savings account, although there is risk involved since they are not insured by the FDIC. Recommended: Savings Accounts vs Brokerage Accounts: How They Compare

Compound Interest vs. Simple Interest 

There are two types of interest, simple and compound.Simple interest is calculated using only your principal balance, or the sum of money you deposited into your account. This type of interest doesn’t account for any interest you've earned over time. So, for example, if you deposit $1,000 at 2.00% interest. Each year you’ll earn $20 in interest. You can only increase the amount you earn by increasing your principal. Fortunately, savings accounts typically offer compound interest. This type of interest does take the interest you earn into account, allowing you to effectively earn interest on your interest. Say you started with $1,000 in your account and earned $3 in interest, the next time your bank calculates interest, they’ll base it on $1,003. That interest will then be added and taken into account the next time your bank calculates interest, and so on. Depending on your account, interest could be compounded daily, monthly, quarterly, or annually. The more frequently the bank compounds interest, the faster your money will grow.Recommended: What Is a Sweep Account?

The Power of Compounding Interest

To understand the advantages of compounding interest over time, let’s compare an account that earns simple interest to one that earns compound interest.Let’s say you put $5,000 into an account with a 3.00% interest rate and simple interest. You will accrue $150 of interest every year ($5,000 x 3.00% = $150). After five years, you’ll earn $750 of interest overall.If you put that $5,000 into a savings account with a 3.00% interest rate but the interest compounds monthly, you would earn $808.08  at the end of five years, rather than $750.

The Takeaway

Savings accounts not only keep your extra cash safe but pay interest, which can help your money grow over time. Banks state their savings interest rates as an APY, which includes compounding (when your interest also earns interest).To find the best savings account for your financial goals, it can be smart to shop around and compare APYs, as well as fees and balance requirements, from a range of institutions. Keep in mind that some online banks may offer higher rates than brick-and-mortar banks or credit unions.If you want to simplify your search, Lantern by SoFi can help. With our online banking marketplace, it’s easy to compare high-yield savings accounts based on APY, fees, and balance minimums all in one placeLantern can help you compare online savings accounts and find today’s best rate.

Frequently Asked Questions

How does compounding interest work?
How much interest can you get on a savings account?
How soon can I start earning interest on my savings account?
How do I know the interest rate on my savings account?
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About the Author

Austin Kilham

Austin Kilham

Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
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