Savings accounts can help you to set aside money for short and long-term financial goals. One of the biggest questions you might have when deciding where to save centers on how much interest you can earn. Knowing how to calculate interest on savings account balances can help you choose the best savings option. A financial advisor could help you create a financial plan to reach your savings goals.
How Does a Savings Account Earn Interest?
Banks and credit unions pay interest on savings accounts for one simple reason: to attract new customers. Financial institutions use money that you deposit into a savings account, along with deposits from other customers, to make loans and investments. It’s in the bank’s interest to draw in new savers with competitive rates.
Savings account interest can take one of two forms. Banks can pay savers simple interest or compound interest and which one you’re earning makes a difference when calculating how much your savings can grow.
Simple interest is the interest earned on the principal balance only. When calculating simple interest on a savings account, you’re only looking at the amount you’ve deposited.
Compound interest, meanwhile, considers both the principal balance and any interest earned. You’ll often hear it referred to as the interest on your interest. Banks can choose how often to compound interest on a savings account. For example, some banks compound interest daily while others compound monthly.
Interest earned on a savings account is usually credited to your account once per month or statement cycle. Between simple interest and compound interest, compound interest can help you to grow your money faster.
How to Calculate Interest on Savings Account Balances
The way that you calculate interest on a savings account depends on whether the account earns simple or compound interest. Each one has its own formula that you’ll use for the calculation. If you don’t know whether your savings account earns simple or compound interest, you can call the bank to ask.
Calculating Simple Interest on a Savings Account
Assuming that your savings account earns simple interest, here’s what the interest calculation formula would look like:
Interest earned = P x R x N
Here’s what each letter in the formula means:
P = Principal or your savings account starting balance
R = Interest rate earned for the year
N = Number of time periods that you’re measuring interest earned
You’ll sometimes see this same formula with a ‘T’ substituted for the N. The ‘T’ stands for time, which for most simple interest calculations is usually one year.
As an example of how to calculate interest on a savings account using simple interest, say you deposit $1,000 into an account earning 1%. Assuming you want to know how much interest you’d earn in a year, the formula would look like this:
$1,000 x 0.01 x 1 = $10
The simple interest calculation is easy to apply if you know the interest rate, the starting balance and how long you want to measure interest growth.
Calculating Compound Interest on a Savings Account
If you’ve got a savings account that earns compound interest, you’ll need to do a little more math. The formula for calculating compound interest on a savings account looks like this:
Interest earned = P(1 + r/n)nt
Here’s what each letter means:
P = Principal or starting balance
r = Interest rate
n = Number of times interest compounds over a one-year period
t = Time you want to calculate interest (measured in years)
Using the previous example, say you deposit $1,000 into a savings account earning 1%, with interest compounding daily. After one year, you’d earn $10.05 in interest. That doesn’t seem much different from the simple interest calculation, but you have to remember that time is on your side when it comes to compounding.
The longer you have to save and the more frequently interest compounds, the more your money can grow. Making regular contributions to savings can also help you to earn more interest over time.
It’s possible to do this calculation yourself but you might find it easier to plug the numbers into an online savings account calculator. SmartAsset’s online savings calculator lets you see how much interest you could earn, whether you’re saving a little money or a lot.
How Can I Earn More Interest on a Savings Account?
If you’d like to earn as much interest as possible with a savings account, the first step is choosing the right savings option. Banks and credit unions can offer a variety of savings accounts, but they aren’t all alike. For example, the interest rate you earn with a savings account at a traditional bank may be much lower than the rate you could get with a high-yield savings account from an online bank. And an online bank may charge fewer fees to boot.
Comparing savings accounts at different banks, online or brick-and-mortar, can help you gauge the rate and APY you could earn. Some of the savings account options you might consider include:
- Traditional savings accounts
- Online savings accounts
- High-yield savings accounts
- Money market savings accounts
- Specialty savings accounts (i.e., Christmas Club savings, wedding savings, etc.)
It’s a good idea to look at whether you’re earning simple or compound interest with a savings account. In the case of compound interest, you’d want to see how often it compounds. Daily compounding, for example, can help you grow your money slightly faster than monthly compounding.
You can also earn more interest by making regular contributions to your savings account. For instance, you can link checking to savings and schedule recurring transfers weekly or monthly. Or you might ask your employer to send part of your direct deposit to savings every payday.
Should I Save Money or Invest?
If you’re interested in growing your money even more, you might want to invest some of your savings. Investing money means you’re putting it into the market rather than parking it in a savings account. For example, you might purchase individual shares of stock, mutual funds or real estate investments.
Investing money can be one of the best ways to capitalize on compounding interest because you stand to earn much higher returns compared to a savings account. For instance, you might get a 2% APY with a savings account but earn 10% or more on your investments.
The longer you have to invest, the more time you have to leverage compound interest to your benefit. Of course, investing money in the market can be riskier than keeping it in a savings account. So, you’ll need to consider your personal risk tolerance and goals when deciding how much to invest and where. Those are things a financial advisor could help you with.
Knowing how to calculate interest on savings account balances is helpful when deciding where to save. You can also use interest calculations to fine-tune your savings goals if you’re not sure how much you should deposit to your account each month. Just remember to check with the bank to find out if you’re earning simple or compound interest to make sure you’re using the right interest formula.
Checking Account Tips
- Consider talking to your financial advisor about developing a plan for saving and investing. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Certificate of deposit (CD) accounts are another way to save. With a CD account, you deposit money, and it earns interest over a set time period. Once the CD matures, you can withdraw your initial deposit and the interest earned or roll it into a new CD. A CD could be a good savings option if you’d like to get a guaranteed rate but keep in mind that withdrawing money before maturity could trigger a penalty fee. Just remember to compare CD rates before opening an account.
Photo credits: ©iStock.com/South_agency, ©iStock.com/fizkes, ©iStock.com/sorrapong