How Interest is Calculated on your Savings

While everyone should care about their savings all the time, this is especially true when people feel the pinch and interest rates are low. This is when everyone wants to know how interest is calculated on your savings.

What is interest?

When you deposit money in a savings account, you are giving it to the bank with the agreement they are holding on to it for you until you come back to take it home again. While they are holding your money, banks use it to make money for themselves by doing things like loaning it to people, giving it out as mortgages, or investing in stocks in hopes of making money. For the privilege of a bank holding on to your money, they pay you interest. This is a sum of money that is proportional to the size of your savings.

Simple annual interest

Interest is generally stated as something like “5% annual”. 5% annual, means that the bank will pay you 5% of your money per year. If you have $1000 in the bank, you would get $50 a year from the bank.  Simple interest means that the bank doesn’t pay interest on interest until after that year is up. After that, the interest they paid into your savings account becomes part of your savings. Using the same example, the first year you would get $50 from the bank, and the second year (if you don’t spend anything) you would get $52.50 – because in the second year you have $1050 instead of the original $1000.

Shorter period interest

Instead of interest being calculated once per year, it is often calculated monthly or even daily. This means the annual rate of interest is divided by the number of periods – 12 months, or 365 days respectively. Each time the interest is calculated it’s a smaller amount than with annual, but if your savings changes during the year you may benefit from having more savings in your account when the interest is calculated many times, instead of just the once each year. It is possible that you will earn less interest the same way if your savings is lower at those times. Be aware that shorter periods of interest are not always better.

Compounded interest

This is what everyone wants to have. Compounded interest is where you are paid interest, then interest on the interest, and so on each time you are paid interest. This way you get the most bang for your buck. Its best to look at an example to see how huge a difference compound interest can make. For example, you invest $1000 for 10 years at 5%. If you invest it with simple interest at the end of 10 years you will have $1500 – the interest was calculated to be $50 each year and was added on at the end of the 10 years. For the same example but with interest paid annually so it can compound, you will end up with almost $1630 – $130 more than with simple interest. Compound interest is why investment advisers tell you to put money into savings as early in your life as you can because even small amounts over long periods of time can grow faster than you can imagine!

Savings accounts are either simple or compound interest, calculated annually, monthly, or daily. Now you can figure out for yourself how fast your savings will grow and which place is the best one for you to put your savings. But remember, it’s always best to consult a financial professional before making big decisions with your life savings.