When I first opened my savings account I didn’t really know how the interest was calculated. It was simply put to me that your money grows slowly overtime at the rate of the interest.
What it really is is the bank pays you in return for holding your money with them. They pay you based on the interest earned from charging their loan customers a higher interest rate. You will get your interest at 0.05% or 1% from that return. Still, sound complicated?
The earned interest on a savings account is like having the bank pay you to leave your money there. The interest earned with a savings account is called compound interest.
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What is compound Interest?
Compound interest helps you earn interest when you first make your deposit, then as you add more funds you earn based on the collective balance. So for example, if you save $500 then you earn interest off of that.
Then add another $500 making it $1000, you will then earn interest off of the $1000. The result is the more you add, the more you earn.
Simple interest is just the interest earned on the principal balance, in our example, it would be just the $500 dollars. It is as if you just withdraw the interest from your account every year, so you will continue to earn on the first deposit. Since interest rates are considerably low, it will be in your best interest to leave it there and earn compound interest.
Calculating The Interest In A Savings Account
Calculating the interest you will earn is simple. Simple as multiplying the amount by the interest rate and by the time period the money is in the account. One formula you can use is: Interest = P x R x N
P = Principle Amount: This is the beginning balance
R = Interest “Rate”: Commonly the interest rate offered for the year. Use this in a decimal form.
N = Number of periods: Generally a one-year time period.
Let’s use this example, how much interest you will earn with $1000 in a savings account? Many savings accounts top at 1% interest per year, so we will take that into account.
So you have $1000 in a savings account that will earn you 1% interest per year. When calculated using the formula with the interest rate expressed as a decimal. Interest = $1000 x 0.01 x 1, which equals $10.00
10 Year Example of $1000
|Years||Total Deposited||Growth Calculated at 1%|
It may not seem like a lot at first, but based on the chart the success of compound interest has good results. Rather than withdrawing out the money leave it there to grow. With the chart above you might be wondering what if I just put in 10,000, well with just simple interest that will result in only $100.
As you can see compound interest at the end of 10 years adds up to $11,682.28. That is the power of compound interest! You can start with 10,000 if you like but remember to add deposits over time.
When comparing interest rates for saving accounts most are lower than 1%. The average savings rate is 0.06%, so as you can see adding more money will earn you more interest.
In our formula above if you added $1000 for 0.06% in a decimal form this would be 0.006. So to calculate it will be Interest = $1000 x 0.0006 x 1 = $0.60
But let’s not forget that it’s a compound interest so over time by adding more the return will be greater.
The good thing is that a lot of online banks have savings accounts that are at 1%, like Chime Bank. Online banks have the privilege of now being brick and mortar and the upkeep of having physical locations. This in return is luck with the interest rates.
How to make most of your savings with compound Interest
Compound interest is a good start to having your money grow. Don’t think of it as money wasted even at a low-interest savings account, it’s still free money. If you want to take advantage of the compound interest add additional deposits throughout the year.
Growing the account balance will earn you more money at the end of the year. Think of your interest-earning potential long term, that would be the best suggestion. Figure out how much it will be in 5 years if you added an extra 1000 a year. In our suggestion above that will come out to $50 versus just 10 dollars.
And it’s important to also note that interest rates in savings accounts can vary. So some harmless comparison rate shopping doesn’t hurt. If you are concerned about a rate change, opt-in for a high-performing certificate of deposit. The interest rate on a CD is a little higher but your money has to stay in that account for a certain time.
Savings account interest is calculated based on the principle balance or deposit multiplied by the interest rate. Then multiply that by the time period, almost like it will be for the year. Take advantage of compound interest versus simple interest by not withdrawing the interest on your account. Simply just add additional deposits throughout the year and see the growth of your savings account.