In a world where it can seem hard to make and stretch a dollar (hello, inflation!), isn’t it nice to know that there’s a way to earn money without any effort? That would be by collecting interest on a savings account. Your financial institution pays you for the privilege of using the cash you have on deposit, pumping up your wealth without the least bit of work on your part.
Knowing how to calculate interest helps you more effectively compare savings accounts.
While the basic concept may sound simple, understanding the different rates offered on interest-bearing accounts (typically savings accounts, though some checking accounts may earn a bit too) can get complex.
Here, you’ll learn the ins and outs of how interest works. For those trying to grow their money to achieve financial goals, it’s helpful to know how to calculate interest on a savings account. This knowledge can help you determine how much money earned in interest you can expect. It can also aid you when you are deciding which savings account best meets your needs.
Read on for insights, including:
• What is interest?
• How do interest rates work?
• How is savings interest calculated?
• What is compound vs. simple interest?
• What is an APY vs. monthly interest rate?
• What’s a good savings account interest rate?
What Is Interest?
Interest is the amount of money that a bank pays a depositor who is keeping their money with the financial institution. While that money remains accessible to the account holder, the bank uses money on deposit for other purposes, such as lending it out for a mortgage loan. One way banks can make money is via the differential between the interest they pay for money on deposit (say, 3%) and the interest they charge when someone else borrows it (say, 6% on a home loan).
Understanding Interest Rates
In comparing savings accounts at different banks (or even within the same bank), consumers may notice that interest rates can vary with the type of account. What’s more, interest rates posted by the Federal Reserve may vary considerably from the interest rates banks offer their customers.
Tasked with maintaining economic stability, the Fed uses signals such as employment data and inflation to determine its rates. During economic slowdowns, the Fed typically lowers rates to reduce the cost of borrowing and incentivize big businesses to spend more, stimulating the economy. Conversely, when the economy appears to be growing too quickly, the Fed may raise rates, increasing the cost of borrowing in order to slow spending. This has been the case in recent years, with the Fed repeatedly raising rates in an effort to bring inflation down.
How does this play into the interest rate consumers might earn on their own savings? There are a number of factors that determine the interest rate a bank posts:
• The target federal funds rate, set by the Fed, is one such cue.
• Banks, however, set their own interest rates and these may vary depending on factors such as promotions the bank may have in place to attract new customers or incentivize greater account balances, as well as how much work an account takes to administer.
This last factor is why checking accounts, which are often used for a higher volume of everyday transactions, often pay less interest than savings accounts, where customers are more likely to let their money sit and accrue.
• Interest rates also change over time, so the posted rate when an account is opened may not remain the same.
• Banks may also have tiered interest rates, where account holders earn different rates of interest depending how much they have in their account, or balance caps, in which an interest rate can only be earned up to a certain amount.
Recommended: What Is a High-Yield Savings Account?
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Interest Calculation Formula
Calculating interest involves some not-too-complex math; in fact, it’s primarily multiplication you need to use. The formula looks like this:
P x R x T = simple interest
P stands for the principal, or the amount on deposit.
R stands for the interest rate, expressed as an annual rate usually, in decimal form.
T stands for time, or how long the money is held by the bank.
How to Calculate Savings Interest
Now, consider how this formula could be used to calculate the interest earned on savings you deposit at a financial institution.
If you deposited $5,000 in a bank for one year at a 3% interest rate, the simple interest after one year would be, using the PxRxT formula:
5,000 x .03 x 1 = $150
So, by calculating savings interest, you see that you’ve earned $150. To put it another way, at the end of one year, your $5,000 would have grown to $5,150.
This, of course, represents simple interest. When putting your money in the bank today, you may well earn compound interest. Read on to see how that works and grows your cash even more.
Simple vs Compound Interest
When you earn interest on the principal amount alone, such as in the example above, it’s called “simple interest.”
But the reason savings accounts can be such an effective tool for growing money is that not only is interest earned on the amount deposited, but the interest also earns interest. This is called compounding.
Depending on the account, interest may compound daily, monthly, or quarterly. Each time this happens, the interest earned to date becomes part of the principal, and the amount of interest earned from the compounding date onwards will be based on both the principal plus the interest earned to date. You might think of it as accelerating your money’s growth as time passes.
Here’s what compound interest looks like in action, using the same $5,000 initial deposit, but that 3% interest compounds on a monthly basis.
• After one month, the account would have $5,000 plus interest totalling one-twelfth of the 3% annual interest, $12.50.
• The next month, the interest would be calculated on $5,012.50, adding $12.53 to the principal for a new total of bringing the new principal to about $5,025.03, and so on.
• At the end of the year, the account would have $5,152.08.
• After 10 years, monthly compounding will grow that initial $5,000 to $6,746.77, without adding a single penny more to the account.
Compounding means you earn interest on the interest you’ve already earned.
Here’s a chart showing the difference simple vs. compound interest can make at a rate of 3% on $5,000 deposit:
| Time | Simple Interest | Interest Compounded Daily |
|---|---|---|
| Account opened | $5,000 | $5,000 |
| 1 year | $5,150 | $5,152.27 |
| 5 years | $5,796.37 | $5,809.14 |
| 10 years | $6,719.58 | $6,749.21 |
| 20 years | $9,030.56 | $9,110.37 |
It may not seem like a huge difference, but adding to the principal regularly can grow your money faster. In addition, seeking out a higher interest rate can of course boost your cash faster as well.
APY vs Monthly Interest Rate
Calculating compound interest can get complicated; the equation involves more complicated math. But some banks simplify an account holder’s potential earnings into a single rate called the annual percentage yield, or APY. The APY factors in both the interest rate and the effect of compounding into an actual rate of return over the course of one year. To calculate how much interest will be earned on a savings account using the APY, simply multiply the principal by the APY.
This simplicity makes APY a more helpful rate to use when comparing interest rates for different accounts or banks, because it includes the effect of compounding, regardless of how frequent. Banks will usually post this information because the APY is higher than the stated interest rate. A savings account interest calculator can be helpful when calculating interest on savings accounts and to see how different rates of compounding will affect earnings.
What Is a Good Savings Account Interest Rate?
What is a good savings account interest rate will vary with the times. During the 1980s, the interest rates on savings accounts were around 8%, while from 2018 to 2021, the average was barely one-tenth of one percent, which could hardly keep pace with inflation.
As you shop around for the right account at the right rate, you may find that online banks offer among the higher rates. Since they don’t have bricks-and-mortar locations, they can pass their savings on to their clients. As of March 2023, online banks were offering in the 3% to 4% range, while some of the big traditional banks were still offering just a fraction of a percentage point.
Questions to Ask When Considering a Savings Account
It’s hard to dispute the appeal of earning money on savings. But in addition to knowing how to calculate interest on a savings account, there are other considerations that could affect the flexibility and ease with which that account will help a person achieve their goals. Some account holders may find they need multiple bank accounts to meet both their everyday and long-term financial needs and goals.
Here are some things to consider.
Will You Be Penalized for Everyday Transactions?
Savings accounts typically provide higher interest rates than checking accounts because they require less work for the bank to administer since they’re not meant to be used for everyday transactions.
But savings accounts may limit the number of transactions or transfers account holders can make in a month, or charge a fee for such actions. The Federal Reserve’s Regulation D, which imposed a six-transaction-per-month limit, was loosened during the COVID-19 pandemic. Some banks now follow the new rule; others don’t. Inquire at a potential new home for your funds before opening a savings account.
Is There a Minimum Balance?
Some banks incentivize or penalize customers to encourage them to keep more money in their accounts. For example, an account may be subject to fees unless the balance is maintained above a certain amount. Tiered savings accounts provide a higher rate of interest on bank balances above certain levels.
Can the Money Be Accessed Easily?
Some types of savings accounts provide higher interest rates but limit access to the money for a predetermined earnings period. For example, a certificate of deposit (CD) is a savings vehicle that holds an investor’s money for a certain period of time. At the end of that term, the account holder is paid the original principal plus the interest earned. There may be penalties imposed on early withdrawals from a CD.
Can the Account Help Achieve Money Goals?
Earning interest is a key way a savings account can help savers achieve their financial goals. But they might have multiple reasons for saving, from being able to afford a vacation or other luxuries to ensuring they have enough money in an emergency fund for unforeseen circumstances. If that’s the case, it’s helpful to be able to know at a glance what is saved towards each need. At some banks, separate accounts might need to be opened for each purpose, while others may provide tools to organize your savings within a single account.
How to Streamline Your Savings
High interest rates can indeed be a compelling motivator for opening a savings account. And knowing how to calculate interest on an account is a helpful tool for finding the right financial product. But incurring fees to make necessary transactions or losing flexibility in other ways may negate the benefits of earning interest.
With a SoFi Checking and Savings online banking account, members can earn a competitive APY and not pay any account fees. Plus, SoFi members can access the Allpoint network of more than 55,000+ fee-free ATMs as well as use Vaults and Roundups to help grow their wealth. Plus, whether online or using the SoFi app, members can spend, save, and earn all in one convenient place.
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SoFi members with direct deposit can earn up to 4.00% annual percentage yield (APY) interest on Savings account balances (including Vaults) and up to 1.20% APY on Checking account balances. There is no minimum direct deposit amount required to qualify for these rates. Members without direct deposit will earn 1.20% APY on all account balances in Checking and Savings (including Vaults). Interest rates are variable and subject to change at any time. These rates are current as of 3/17/2023. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
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