Earning money without doing anything at all sounds like the subject line of a spam email. But there is one striking example of where this promise is not a scam at all: earning interest on a savings account.
Interest-bearing savings accounts are one example of an accessible way a saver can put their money to work. Money deposited into savings accounts is essentially money lent to the bank and typically earns interest for the depositor.
This sounds simple—but only in theory. Interest rates can vary depending on the bank and the type of interest-bearing account. While some checking accounts pay interest, too, it’s typically at a negligible rate compared to savings accounts.
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 will help determine how much money earned in interest can be expected and help savers make a decision when trying to find the right savings account to meet their needs.
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. Nor may the interest rates posted by the Federal Reserve align with 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.
How does this play into the amount of interest 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. But banks 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 savings can only be earned up to a certain amount.
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Simple vs. Compound Interest
In simple terms, understanding how much interest money earns in a bank account is as simple as multiplying the interest rate by the amount of the principal. For example, if a person earns 1% interest on a $5000 deposit, they would have $5050 at the end of the year: $5000 from the principal and another $50 in interest (1% of $5000). When you earn interest on the principal amount alone, such as in this example, it’s called “simple interest.”
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But the reason savings accounts can be an effective tool for growing money is that not only is interest earned on the amount deposited, that interest earns interest, too. 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.
Here’s what compound interest looks like in action:
For example, an account with the same $5000, but that 1% interest compounds on a monthly basis.
• After one month, the account would have $5000 plus interest totalling one-twelfth of the1% annual interest (about $4.17).
• The next month, the interest would be calculated on $5004.17, bringing the new principal to about $5008.34, and so on.
• At the end of the year, the account would have $5050.23.
While those extra 23 cents may not go far, that money continues to compound over the lifetime of the savings account. After 10 years, monthly compounding will grow that initial $5000 to $5525.62.
The more frequently interest on an account compounds, the more the money will grow as well. For example, if the 1% interest rate on $5000 compounds daily, the account would have $5050.25 at the end of one year, and $5525.85 after 10 years. The more money a person saves, and the more frequently they save it, the greater the effect compounding will have on their savings account balance.
Calculating compound interest might sound complicated 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 compound interest calculator can be helpful when calculating interest on savings accounts and to see how different rates of compounding will affect what earnings.
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 several 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 recently temporarily amended to do away with the limit, although banks are not required to follow the new rule.
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 emergency funds 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 up to 1.25% APY without incurring account fees. Plus, SoFi members can access perks like no-cost financial planning, referral bonuses, and estate planning services. Whether online or using the SoFi app, members can spend, save, and earn all with one product.
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SoFi members with direct deposit can earn up to 1.25% annual percentage yield (APY) interest on all account balances in their Checking and Savings accounts (including Vaults). Members without direct deposit will earn 0.70% APY on all account balances in their Checking and Savings accounts (including Vaults). Interest rates are variable and subject to change at any time. Rate of 1.25% APY is current as of 4/5/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
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