How Interest Works on a Savings Account

The interest you earn on your savings account is a percentage of the money you have deposited in the bank. In compound interest, the first interest amount is added to your deposit, and then the next interest amount is calculated based on the new higher amount.

When compound interest is calculated on a savings account, it considers the principal amount and all the earlier interest amounts from previous periods. In compounding, all your interest amounts are reinvested, and successive interest is given to these higher amounts.

In this article, we will understand what interest is on savings account and how does savings account interest work.

Interest is the amount of money you are given by a bank, financial institution, or credit corporation for parking your money with them in their savings account. The amount of interest that they will pay you depends on multiple factors, such as the quantum of your cash balance, the interest rates, and the frequency with which these interests are compounded.

The interest you earn on your savings account over a given year is known as an annual percentage yield (APY). However, savings accounts from various banks and institutions differ in terms of the interest they offer. For instance, the interest rate offered by a large traditional bank will often be lower than the one offered by an online high-yield savings account or a neo bank.

Hence, if you want higher rates of interest or APY for your savings account deposit, it is essential to research and compare the rates offered by different financial institutions to ensure you get the best deal.

If you are looking to diversify your investments portfolio, Fixed Deposit (FD) can be a good choice. FDs provide a fixed interest rate throughout the investment period. Interest rate on FDs does not change with market fluctuations.

Banks and financial institutions use customers' deposits to fund and distribute loans and make other investments that generate revenue for them. By paying interest, they ensure customers park their corpus in their savings account deposits. Simply put, the customer acts as a lender here by lending money to the bank, for which the bank is obliged to pay interest.

You have the freedom to withdraw this amount as per your requirements, but this deposit account also sits on the bank’s balance sheet as they use it to fund other investments.

Simple interest vs. Compound interest

Simple interest is when the interest rate offered by a bank is applicable only to the principal amount in your savings account and is calculated on an annual basis.

The formula for simple interest is:

Simple interest = Principal x Rate of interest x Time

Now, let us understand how a savings interest works.

Let's say you have Rs. 1,00,000 in a savings account with a simple interest rate of 2.00% APY. Using the formula, here is how much you would earn: 1,00,000 x 0.02 x 1 = Rs. 2,000.

That means you would earn Rs. 2,000 in a year, leaving you with a new balance of Rs. 1,02,000.

In compound interest, the rate of interest applies to both the principal and the interest generated by the principal, or accumulated interest. Compound interest is generally calculated either daily, monthly, or quarterly. The compounded interest is transferred to your account at the end of each statement period.

The formula for compound interest is,

A = P(1 + r/n)^nt

Where,

A: Total amount accumulated (initial principal + interest)

P: Initial principal amount

r: Annual interest rate (as a decimal)

n: Number of times the interest is compounded per year

t: Time in years (e.g., 6 months would be 0.5 years)

Now, if we were to use this formula for our above example, the interest compounded monthly, i.e., every month, your interest is added to your principal, and then the new higher amount is treated as principal next month for calculation of interest. The compound interest you will earn at the end of the year is Rs. 2,013.

Although this amount may seem negligible at present, over time and with a larger sum of invested capital, the gains can become significant. This is the power of compounding, which generates returns not just on principal but also on interest.

Hence, compounding increases the value of an account or principal amount faster than simple interest. The more often compounding occurs, the more your deposit value will grow with time.

You can consider investing Bajaj Finance Fixed Deposit. With a top-tier AAA rating from financial agencies like CRISIL and ICRA, they offer one of the highest returns, up to 8.85% p.a.

If you want to open a savings account and get a good interest rate, it is crucial that you research the different options available in the market, compare their interest rates, and only then come to a conclusion.

It is important not to get swayed by the first offer that you receive because another source could offer you higher returns or lower operational fees.

Another important thing to remember is to select the right type of account conducive to your needs and goals. For example, a certificate of deposit delivers higher returns than other savings accounts, but it also limits your access to your money until the maturity date. So, even though these savings instruments provide you with a higher APY, they may not be a good option if you want easy accessibility and liquidity at all times.

Understanding how savings interest works is crucial for making informed financial decisions, especially in today’s economic climate. With recent increases in interest rates, it’s essential to evaluate the different savings products available, considering factors like compounding effects and access restrictions.

Taking advantage of the current high interest rate environment can significantly benefit your savings. Opting for high-yield savings accounts, which offer competitive rates, can accelerate your wealth-building process. By keeping your money in these high-interest accounts, you can continue to earn interest, enhancing the growth of your savings over time.