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How Savings Interest Works

Understanding the difference between simple and compound interest can add up to huge savings.

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Opening a high-yield savings account is the first step in the process of working through a solid savings strategy. While your income, spending habits and managing your finances will ultimately drive the balance of that account, the type of account you select will affect how quickly your money grows.  Any bank or credit union that pays interest on your savings account will add to your bottom line -- but a few percentage points more will make a difference in what you earn, especially over the long term.

How a savings account works

When you deposit your money in a savings account, the bank doesn’t keep all that cash in a safe. Instead, the bank puts your money to work by loaning it to other customers.

Don’t worry -- your money is protected, even if the other customers don’t repay the loan, thanks to insurance from the Federal Deposit Insurance Corporation for banks or the National Credit Union Administration for credit unions. As banks earn interest on the money they loan to borrowers, you earn interest on your deposited cash. 

When banks charge higher rates for loans, they usually offer higher rates to savers. So, when you see interest rates on mortgages increase, for example, you’ll often see savings interest rates, referred to as the APY, or annual percentage yield, typically move in the same direction.

The APY represents your total annual earnings, regardless of whether your financial institution pays simple interest or compounding interest. If you deposit $20,000 in a savings account that advertises a 2.35% APY, for example, you stand to earn $469.41 in interest over the course of the year, assuming the rates don’t change, simply for letting your money sit there.

How to calculate simple interest for a savings account

Estimating your potential earnings from simple interest for a savings account is fairly… simple. Take your principal deposit, and multiply it by the interest rate to forecast your earnings for the year. For example, a $5,000 principal that earns 5% interest each year looks like this:

$5,000 x 0.05 = $250

Simple interest accrues on the money deposited. So, you’ll earn interest only on the money you deposit in the savings account, not on the $250 that you earn in interest. You’ll need to make sure that your savings account compounds to earn interest on your interest.

How compounding interest works

When interest compounds, the earnings are constantly multiplying. Rather than earning interest solely on the principal balance, you’ll earn interest on the total balance as it grows. Some accounts compound interest daily; others less frequently, such as weekly, monthly or quarterly.

Daily compounding is the most lucrative, providing more opportunities for your cash to grow. For example, a $5,000 deposit that earns 5% interest compounding annually would earn $250 of interest in the first year. What about an account that compounds daily? The first year comes out to $256 in interest. An additional $6 might not blow your mind, but every penny counts when you’re trying to grow your money.

Consider the math in the table below. After depositing $5,000 in an account that earns 5% with interest compounding daily, your balance will be more than $3,000 higher after 10 years from interest growth alone.

$5,000 at 5% interest rate, compounding daily

Beginning balanceBalance after 1 yearBalance after 5 yearsBalance after 10 years

To truly take advantage of compounding, deposit money in your savings account on a consistent basis to increase your overall balance. Consider this example of the same account with an additional savings deposit of just $50 per month.

$5,000 (plus $50 monthly deposits) at 5% interest rate, compounding daily

Beginning BalanceBalance after 1 yearBalance after 5 yearsBalance after 10 years

Long-term benefits of compounding

Financial experts often describe compounding as a snowball. As you roll a snowball through a fresh layer of snow, it gets bigger and bigger. Compounding interest acts similarly: Earning interest on your interest can supercharge your rate of return.  

Consider that initial $5,000 deposit with 5% interest compounded daily. Over 10 years, that adds up to $3,243 of additional interest -- a nice size snowball.

By adding just $50 a month to your savings, with interest compounding daily, your snowball will have ballooned to about $11,000 in interest. That’s a snowball worth getting excited over!

How to earn more interest in a savings account

If you’re looking to accelerate your earnings, deposit your money in a high-yield savings account and look for institutions that compound interest daily. Banks with fewer brick-and-mortar branches -- or no physical branches at all -- have lower operating costs and tend to pay higher interest rates.

But you don’t necessarily have to put your money into a savings account to take advantage of compounding interest. The APYs for the best money market accounts and certificates of deposit are also increasing. Just make sure you understand the tradeoffs that come with each kind of account.

The bottom line

As the Federal Reserve attempts to stem inflation, interest rates are rising at many banks and credit unions. Taking advantage of a high-yield savings account that compounds daily or monthly will give you the best growth potential for any money you have parked in savings. 


Remember, savings accounts are variable-rate products, so the APY can change at any time. Locking in a high-yield fixed-rate APY with a CD has advantages, but it will limit your access to deposited funds without incurring a penalty if you withdraw money before the CD matures. Understanding your options and taking advantage of rising rates will benefit you in the long run.

David McMillin writes about credit cards, mortgages, banking, taxes and travel. Based in Chicago, he writes with one objective in mind: Help readers figure out how to save more and stress less. He is also a musician, which means he has spent a lot of time worrying about money. He applies the lessons he's learned from that financial balancing act to offer practical advice for personal spending decisions.
Toni Husbands is a staff writer with CNET Money who enjoys exploring topics that promote financial wellness. She began writing about personal finance to document her experience paying off $107,000 of debt, which is detailed in her book, The Great Debt Dump. Previously, she contributed as a freelance writer for websites, including, Centsai and Wisebread. She was also a regular contributor to Business AM TV, and her work has been featured on Yahoo News. Being a part-time real estate investor and amateur gardener also brings her joy.
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