For those of you who are wondering, interest is the money you receive for loaning out funds, and it is also the money that you pay when you borrow funds. Basically, it is the amount charged for the opportunity to use someone else’s money.
If your savings account earns interest, it is because your bank or credit union is likely using the funds in it to make loans. In return, the bank will pay you interest. The more that you deposit and the higher the interest rate, the more your account earns. Credit unions have a similar processes, but they will call them dividends.
The national average in terms of savings rates is actually 0.07% APY, but some institutions, especially online savings accounts, offer much higher yields than that, often 10 times more than the national average.
What is an interest rate?
Interest is normally displayed as a percentage of the borrowed or deposited amount, and that percentage that you see is known as the interest rate. For deposit accounts that earn interest, the rate over a one-year time period is known as the annual percentage yield, or APY.
If you are borrowing money, a higher rate means you will be paying more for the privilege of using money, making the loan actually more expensive than is stated. However, if you are earning interest, a higher APY means more money in your account. When it comes to opening a savings account, it make sense to shop around for a high-APY option.
What’s the difference between interest and compound interest?
Once your bank pays you interest for the privilege of using your money, you can withdraw the funds or leave them deposited. If you leave them in your account, that money also starts earning interest, on top of the original deposit, allowing your overall balance to grow more. This is known as “compound interest.” Taking advantage of compound interest helps you build up money faster over a period of time. This allows your cash to work for you, which is great when rates are low.
Let’s take a look at how interest works. Let’s say you put $6,500 in an account that pays a 0.55% rate, you’d calculate the interest earned by multiplying the balance and the rate: $6,500 multiplied by 0.55% is $36, so you’d earn $36 in interest. It may not seem like a lot over the course of a year, but it’s more than the roughly five bucks you’d earn at the national average rate of 0.07%. Also, that $36 will continue to earn interest if it’s left in the account.
If the account earns 0.55% APY over a three-year period, the balance after that time would be more than $6,600. For an even better scenario, add in a monthly savings plan. Say you start with a $6,500 balance and deposit $100 monthly over a three-year period. The balance would swell to more than $10,200 with the added interest.
Keep in mind that interest rates on savings accounts vary quite a bit and can change depending on the time. Banks also offer certificates of deposit, or CDs, which give you a set interest rate for a certain time period, say six months or five years. Consider selecting an account that gives you strong interest rates and the ability to your grow your balance easily. For more posts like this, check out our list of bank guides!