Savings Account Interest

Opening a traditional savings account is a good place to start saving money and earn a return through interest. While rates are lower now, understanding how banks calculate, pay, and compound interest helps maximize earnings on savings. This guide covers common questions around savings interest rates, terms, and optimization strategies.

How Do Savings Accounts Earn Interest?

Banks pay depositors interest on savings accounts by:

• Lending out deposits to consumers/businesses at higher interest rates and paying savers a portion of earnings.
• Investing pools of savings account deposits to earn investment income, some of which is passed to account holders as interest.
• Using the total deposited funds across all accounts to provide capital for issuing new loans and collecting associated interest.

Paying interest provides incentive for consumers to keep money deposited in the bank rather than holding physical cash.

What Factors Influence Savings Interest Rates

Primary elements affecting savings account interest rates include:

• Federal Reserve interest rate policy – Rates set by the Fed influence rates banks can offer. When the Fed cuts rates, bank savings rates follow.
• Bank competition – To attract more depositors, banks may pay higher rates than competitors, especially online banks.
• Account balance – Higher balances may qualify for higher incremental rates. Tiers range from 0.01% up to 0.60% APY based on deposit size.
• Account restrictions – Accounts with limited withdrawals or other conditions needed to earn interest may offer better rates.
• Overall economic conditions – When the economy faces challenges, rates drop across the board.

Shop around as rates vary widely between banks and account types.

How Are Savings Interest Rates Calculated?

Two key factors determine the interest earned on a savings account:

Annual Percentage Yield (APY)

The APY reflects the total annual interest amount paid on the account, factoring in compounding. A higher APY earns more interest.

Deposit Balance

The average or minimum account balance required determines the actual interest dollar amount earned, based on the account’s APY.

Bigger balances earning higher APYs maximize interest earnings. Read terms carefully to understand tiers.

Compound Interest Boosts Returns

Compound interest increases savings growth exponentially over simple interest by earning interest on interest. For example:

Simple interest on $1,000 at 1% annually

Year 1: $1,000 x 0.01 = $10 interest

Year 2: $1,000 x 0.01 = $10 interest

Total interest earned = $20

Compound interest on $1,000 at 1% annually

Year 1: $1,000 x 0.01 = $10 interest

Year 2: ($1,000 + $10 interest) x 0.01 = $10.10 interest

Total interest earned = $20.10

Small yearly boosts compound into bigger long term gains.

When Do Savings Accounts Pay Interest?

Timing for crediting interest varies:

• Interest Payment Frequency – Monthly, quarterly and annually are common options. Monthly compounds fastest.
• Interest Accrual – Interest starts accruing day 1 for any deposit, but may not be paid until the scheduled frequency.
• Interest Calculation – Interest earned is calculated daily based on the end-of-day balance but is not distributed daily.
• Interest on Withdrawals – No interest is earned for the day a withdrawal posts.

Understand your account’s payment cycle to predict interest accrual.

Strategies to Earn More Interest

Some options to maximize savings account interest earnings include:

• Chasing Introductory Rates – Open accounts advertising special promotional rates for a limited time.
• Comparing Compounding Frequency – Monthly and daily are best for speed.
• Maintaining Higher Balances – Watch for tiered rates rewarding bigger balances.
• Limiting Withdrawals – Restrict transfers and withdrawals to qualify for higher-yield savings options.
• Using an Online Bank – Online banks tend to offer the highest standard savings rates.
• Laddering CDs – Open multiple CDs with staggered maturity dates to increase long term returns.

A little time researching your strategy can pay off with higher interest income.

Alternatives Offering Higher Returns

While very liquid, savings accounts provide quite low rates now. Alternatives like Certificates of Deposit (CDs) and money market accounts offer higher yields:

CDs

• Time deposit that guarantees fixed interest rate return over 1 month to 5 years
• Penalty for early withdrawal
• Interest rates currently 10X or more than basic savings accounts

Money Market Accounts

• FDIC-insured accounts with limited debit transactions
• Higher interest earnings than basic savings
• Rates variable but tied to bond market indexes

Compare tradeoffs like liquidity, risk, and return to select your optimal savings options.

Even with today’s lower rates, savings accounts play an important role as a safe place to build emergency, goal, and discretionary funds. Optimizing interest earnings by shopping around provides the best opportunities to grow your money in the background as you save.