How savings account interest works

Savings accounts come in various forms. Traditional savings accounts are the most common, offering easy access to funds with a minimal interest rate. Money market accounts typically provide higher interest rates and come with check-writing privileges, making them a hybrid between a savings and checking account. High-yield savings accounts often have significantly higher interest rates, helping savers maximize their earnings.

Knowing how interest works on a savings account is a key factor in choosing the right one. Here's what to know when selecting a savings account.

What is a savings account?

A savings account is a financial tool designed to help individuals safely store and grow their money. Its primary purpose is to provide a secure place to keep funds while earning interest. Savings accounts are a key component of financial planning, offering a way to set aside money for future needs or unexpected expenses.

How does interest work on savings accounts?

One of the most powerful concepts in savings account interest is compound interest. Compound interest means that the interest earned on the savings account is added to the principal balance, and in subsequent periods, interest is earned on the new total balance (principal + interest).

To understand this better, let's consider simple interest, which is calculated only on the principal amount. For example, if a savings account has $1,000 in it and an annual simple interest rate of 5%, the interest earned in one year would be $50.

However, with compound interest, not only would the principal amount earn interest, but the interest earned would also earn interest, leading to a more substantial increase in the total balance over time.

What to look for in a savings account

Choosing a savings account involves evaluating several key factors to ensure it aligns with one's financial goals and needs. Here are some important considerations:

• Interest rate: The annual percentage yield (APY) of a savings account reflects the total amount of interest earned on the account over a year. So, a higher APY can significantly boost savings over time.
• Minimum balance requirements: Choose an account with minimum balance requirements that can be comfortably met to avoid penalties and ensure continuous interest accrual.
• Fees: Monthly maintenance fees, withdrawal fees, and fees for falling below the minimum balance can erode the interest earned on a savings account.
• Accessibility: While savings accounts are not designed for daily transactions, easy access through ATMs, online banking, and mobile apps may be necessary.
• Account features: Look for accounts that offer online banking platforms, mobile access, automated transfers, and tools for tracking savings goals.

Interest rates and APY: Understanding the numbers

When it comes to APY vs. interest rates, the interest rate is the basic rate at which interest is earned on the account's principal balance. In contrast, APY takes into account the effect of compounding, showing the total amount of interest earned over a year. APY provides a more accurate reflection of the potential earnings from a savings account.

Interest rates are determined by banks based on various factors, including the federal funds rate set by the Federal Reserve, the overall economic environment, and the bank's own policies and competitive strategy.

Minimum balance requirements

Minimum balance requirements are thresholds set by banks that dictate the minimum amount of money that must be maintained in a savings account. Failing to meet these requirements can result in fees, such as monthly maintenance fees, or lower interest rates. Look to choose an account where maintaining the minimum balance is feasible.

To help avoid fees, consider the following practices:

• Opt for savings accounts with no minimum balance requirements.
• Set up automatic transfers to ensure the balance stays above the required minimum.
• Regularly monitor account balances using online or mobile banking tools to avoid falling below the threshold.