How Does Interest Work on a Savings Account?

How Does a Savings Account Earn Interest?

There are two types of interest: simple interest and compound interest. While most savings accounts earn compound interest, it's worth understanding how simple interest works too.

Simple Interest

Simple interest is expressed in annual percentage yield (APY) and is calculated based on your principal balance (the amount you deposit in the savings account).

For example, if you put $10,000 into a savings account with a 1% APY, you would earn interest of $100 annually (1% of $10,000). Assuming the account's APY stayed the same, at the end of the year, you'd have $10,100 in your account.

Next year, you'd earn 1% interest (or $100) on the original principal of $10,000, but not on the $100 in interest. At the end of the second year, you'd have $10,200; at the end of the third year, $10,300; and so on.

Compound Interest

Savings accounts typically offer compound interest, meaning you earn interest both on your principal balance and on the interest it earns. Calculating returns from compound interest is a bit more complicated than figuring out returns from simple interest. Depending on the account, interest may compound daily or monthly, which affects the calculation. The more frequently interest compounds, the faster your money grows.

How much interest you'll earn is expressed as an APY, like with simple interest. Looking at APYs is an easy way to compare apples to apples when you're researching savings accounts.

How to Calculate Simple Interest on a Savings Account

To calculate simple interest on a savings account, you'll need to know the account's APY. Here's the formula for calculating simple interest:

P × R × N = Simple Interest

• P = Principal amount
• R = Annual interest yield (APY), expressed as a decimal
• N = Number of years

Using the previous example, here's how much simple interest your $10,000 deposit in a savings account would earn in three years.

• P = $10,000
• R = 0.01
• N = 3 years

$10,000 × 0.01 × 3 = $300

How Often Does a Savings Account Earn Interest?

Savings accounts generally compound interest either daily or monthly. The more frequently interest compounds, the faster your money grows. However, the frequency of compounding isn't the only factor determining your interest earnings. How much money you deposit, how long you leave it there and the account's interest rate all affect the total amount of interest you will earn.

Interest rates on savings accounts are typically variable, meaning they can go up or down based on the federal funds rate, a benchmark interest rate set by the Federal Reserve. The Fed has raised this rate 11 times since March 2022; currently, it's 5.25% to 5.5%. Rising interest rates make it more expensive to borrow money or carry credit card debt. The silver lining: They can boost your savings if your bank or credit union increases rates on deposit accounts.

How to Earn More Interest in a Savings Account

Despite record high interest rates, many standard savings accounts don't pay much interest. The average interest rate on a traditional savings account was just 0.45% as of September 18, 2023, according to the Federal Deposit Insurance Corp. (FDIC). One-fourth of consumers in a 2023 Experian survey said they're earning 1% or less on their savings.

To boost earnings on your savings, consider these options.

Open a Money Market Account

Money market accounts combine features of both savings and checking accounts. They usually offer higher APYs than traditional savings accounts; as of September 18, 2023, the average APY on a money market account was 0.65%. You can typically write checks and make debit card purchases with a money market account, which you can't do with savings accounts.

On the downside, money market accounts may have high minimum balance requirements or fees and may impose limits on how often you can withdraw money without paying a fee.

Open a Certificate of Deposit

If you're saving for a relatively distant goal, like a vacation next year or buying a home once mortgage interest rates drop, a certificate of deposit (CD) could be an option. CDs typically boast higher APYs than traditional savings accounts or money market accounts, and usually have fixed interest rates.

The tradeoff: CDs are less liquid than savings accounts. If you pull out funds before the CD matures, you may have to pay a penalty, usually a certain amount of interest. As of September 18, 2023, average interest rates are 1.37% for a three-month CD and 1.76% for a 12-month CD. You can find CDs with terms ranging from one month to 60 months at banks and credit unions.

Open a High-Yield Savings Account

High-yield savings accounts typically feature much higher interest rates than traditional savings accounts, money market accounts or even CDs. As of September 2023, you can find high-yield savings accounts with APYs north of 5%. (For comparison to our earlier example, a $10,000 deposit in a high-yield savings account with a 5% APR compounding monthly would earn $511.62 in one year.) Many high-yield savings accounts are offered by online-only banks and have low or no fees and don't require maintaining a minimum balance.

The Bottom Line

When choosing among savings options, APYs aren't the only factor in the equation. Also consider account fees, minimum deposit and balance requirements, and the ease of managing and accessing your funds.

Bank accounts don't directly affect your credit score because banks don't report account activity to credit bureaus. However, having a solid savings account to draw on can make it easier to pay your bills on time, which can help improve your credit score. Just as choosing a savings account with a high APY is an easy way to boost your savings, signing up for Experian's free credit monitoring service is a simple way to keep tabs on your credit and get alerts of any important changes.