How does interest work on a savings account?

It may come as no surprise that a savings account is a good place to store your money, especially now that interest rates are rising.

Over the course of 2023, the Fed raised rates several times in an effort to prevent runaway inflation. While inflation has impacted savings accounts by eating away at the purchasing power of each dollar, these higher rates led to more favorable savings account interest rates in 2023 for consumers.

This means that with a savings account in 2023, you have the potential to earn more money with your money.

So how does savings account interest work? Fair question. It’s one that puzzles many. Yet understanding how interest works on a savings account is an important part of maximizing the earnings on your hard-earned, carefully stashed, cash.

We’ve got just the overview of how interest works on a savings account to get you started:

What are savings account interest rates?

At its simplest, interest is the cost of borrowing money. Generally, you’ll pay interest to borrow money, and you can collect interest when you lend money.

But who’s going to pay you to borrow your money? For many people, opening a savings account is one of the easiest ways to go about this. When you put money in a savings account, the bank is technically borrowing the money and paying you interest in return.

“The bank determines the rate, although it’s affected by the general level of rates in the economy and whether the bank is trying to attract new deposits,” says Liz Weston, CFP^®, columnist at a personal finance website.

How does savings account interest work?

As you’re considering how does bank interest work, keep in mind that the interest rate determines how much money a bank pays you to keep your funds on deposit. However, Michael Griffin, a certified public accountant and finance lecturer at a college in Massachusetts, says you should use the annual percentage yield (APY) to compare savings accounts and other savings products.

“The simple way to look at the APY—it’s what you will get on your money,” Griffin says. Meaning, you can use the APY to determine how much you’ll actually earn in interest each year because the APY relies on two inputs: the interest rate and how often the interest compounds. Both are important components of how interest works on a savings account because they impact how much money you’ll earn over time. Your savings account interest could compound daily, monthly, quarterly, or annually.

Suppose you deposit $5,000 into a savings account, don’t deposit or withdraw any more money, and the interest rate doesn’t change. If the account has a 1.00% interest rate and the interest compounds annually—that is, the bank pays you interest on your balance once each year—you’ll earn $50 after the first year. The APY will also be 1.00% in this example because your interest didn’t compound multiple times during the year.

If a bank offers a 1.00% interest rate on a savings account, the rate of compounding could affect the APY and your earnings, although the differences may be minor.

When interest rates are low, there isn’t a huge difference on smaller balances. However, your earnings can increase over time, especially when the savings account offers a higher interest rate and APY, and you’re regularly depositing money into your account.

Lucky for savers, many banks offer savings accounts with interest that compounds daily or monthly, rather than annually.

What are the best savings interest rates in 2023?

You might wonder what are some of the best savings interest rates in 2023? Currently, the national average savings account interest rate is 0.51%, according to Bankrate.com.

But that’s an average. Different institutions offer their own interest rates, with rates that start at 0.01%. This means that an answer to the question “how much interest does a savings account earn?” largely depends on which savings account you’ve chosen.

Typically, online banks like Discover® can offer more competitive savings account interest rates than their brick-and-mortar counterparts. For example, an online savings account with Discover offers an APY that can earn you over 5x* the national average.

Where interest meets account fees and features

Understanding how interest works on a savings account and comparing the APY offered at several banks are important steps in choosing where to open an account.

Weston says you can often get better returns from an online savings account because online banks don’t have to pay for branches and can pass the savings on to consumers. Online banks therefore “have advantages over traditional banks,” she says, “typically, no minimum account balance requirements or fees.” For example, a Discover Online Savings Account comes with no account fees.

It can be a smart idea to research banks with no monthly fees since overdraft or ATM fees can really add up. These fees could offset your interest earnings or even cost you more than you earn. Other potential expenses include fees for bank checks or outgoing wire transfers.

Use a savings account for your financial goals

So, what is interest on a savings account? Now that you’ve seen how interest works on a savings account and understand the nuances that surround how much interest does a savings account earn, you can put your new knowledge to work. Whether you’re saving for a new car, a vacation, or you want to build up or start an emergency fund, having a savings strategy can help you meet your goals.

Weston says without a minimum deposit requirement, you could use online savings accounts and “set up as many accounts as you like and name them for different goals: vacation, holidays, property taxes, and so on.” Separating your funds into multiple savings accounts earmarked for specific purposes can make it easier to resist temptations to spend randomly, which can ultimately help you reach your financial goals sooner.

If you want to focus all of your efforts in one place, another option is to have one account where you keep all of your savings. You could then use a spreadsheet to categorize your funds by bills, expenses, or financial goals.

These are just two examples. Have a different idea about how to organize your savings? Try it out. As long as you’re progressing toward your goals and using your newfound understanding of how interest works on a savings account, you’re headed in the right direction.

Did you know you can use more than one savings account to reach your financial goals? See how you can keep your savings organized and on track with multiple savings accounts.

¹ The Annual Percentage Yield (APY) for the Online Savings Account as of XX/XX/XXXX is more than five times the national average APY for interest bearing savings accounts with a balance of $500 as reported by Curinos as of XX/XX/XXXX. National average is based on information regarding the top 50 banks (by deposit size) and may not include information from variations in regional pricing at such banks or information from products that may not be widely available to their customers. Rates were obtained from Curinos, who relies on the data from the banks it tracks and such information cannot be guaranteed. APYs are subject to change at any time.

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