Understanding Interest

Interest on a savings account refers to the money that a bank or financial institution pays you for keeping your funds with them. Compound interest occurs when the interest you earn is added to your initial deposit, and future interest is calculated based on the new, higher balance.

With compound interest, the interest is calculated not only on the original deposit (the principal) but also on the interest accumulated from previous periods. In other words, your earnings are reinvested, allowing you to earn interest on both your initial deposit and the interest that has been added.

Savings account interest rates allow you to grow your money over time. Banks essentially borrow money from depositors by using the deposited funds to lend to other customers. In exchange, the bank pays interest on the savings account balances while charging loan customers a higher interest rate than what is paid to depositors.

Compounding Interest

With simple interest, a $1,000 deposit earning 1% interest over one year would result in $1,010 at the end of the year (1% of $1,000). This calculation is based on simple interest, where interest is only applied to the principal amount.

Some depositors, like retirees, may withdraw the interest or transfer it to another account, treating the interest as income. In such cases, the account will earn simple interest because no interest is earned on the withdrawn interest.

However, some depositors choose to leave the interest in their savings account, allowing it to accumulate and earn interest on both the initial deposit and the interest earned, which is the basis of compound interest.

The Power of Compounding Interest

In savings accounts, interest can be compounded at different intervals—daily, monthly, or quarterly. The more frequently interest is compounded, the faster your savings grow.

For example, with a $1,000 deposit and daily compounding, interest is added to your balance each day, growing by 1/365th of 1%. After one year, this deposit would grow to $1,010.05, compared to the $1,010 it would reach with simple interest.

Though an extra $0.05 might not seem significant, over a span of 10 years, that $1,000 would grow to $1,105.17 with daily compounding. The 1% interest rate, compounded daily, adds more than 10% to the value of your investment.

While this may still seem like a modest gain, imagine saving $100 per month and adding it to the initial $1,000 deposit. After one year, your balance would reach $2,216.05, with $16.05 earned in interest. After 10 years, continuing to add $100 a month, you’d have earned $725.50 in interest, bringing your total balance to $13,725.50.