You may be committed to storing your money in a safe place, but how do you calculate interest on a savings account?
One very good reason why people save is not just for the rainy day, but also to get added income from the interest on their savings.
Interest on a savings account is the amount of money a bank or financial institution pays a depositor for holding their money with the bank.
How does interest work on a savings account?
It is no longer in doubt that a savings account is a good place to store your money.
But while a savings account sounds like a sweet deal, you may still be wondering how savings account interest works.
Understanding how to calculate interest on a savings account is an important part of maximizing the earnings on your hard-earned money.
Simply put, a bank borrows money from its depositors by using the deposited funds to lend money to other customers. This generates funds for the bank and they, in turn, share some of the proceeds with the depositors in the form of interest.
The bank determines the interest rate of a savings account.
Why put money in a savings account?
There are reasons why it makes sense to put money in a savings account;
Putting money into a savings account allows you to earn interest on your balance. Some current accounts pay interest, but many do not.
Money left to sit in a non-interest-bearing current account doesn’t have a chance to grow.
Save, not spend
Having a savings account may help you avoid spending money that’s earmarked for a specific goal. Keeping all of your money in a current account, for example, could make it easier to spend money you intend to save.
Even if you don’t have a savings goal, having money in a savings account can make it easier to pay bills and everyday expenses in case of an emergency.
With savings, you don’t have to turn to a high-interest loan. And if you don’t have to use your savings for an emergency, you can keep growing your money without having to worry about racking up debt.
Keeping your money in a savings account also offers a measure of protection. If you were to keep cash at home, for instance, it could be stolen.
Walking around with a wallet full of cash could also put you at risk of impulse spending.
What are the different types of interests?
The two main types of interest are simple interest, and compounding interest.
As the name implies, simple interest is money earned only on the original sum of money saved.
Compound interest however gives you interest on your interest. This means, if you’re earning interest in a savings account, that interest will also earn interest over time.
This process is called compounding, and your overall earnings will be a bit higher than what’s calculated with the simple interest formula.
Assuming your account has earned N100 in interest. If you leave that extra bit of money in your account, it will also start earning interest during each compounding period.
Many online savings accounts compound daily. Compound interest helps your bank balance grow faster over time, even if the interest rate is low.
The rate of compounded interest earned over a year is expressed as the Annual Percentage Yield, or APY.
You will typically see savings account rates expressed as an APY.
To calculate interest earned on savings for one period, the following formula applies.
- Simple interest is calculated using three elements; Principal, Rate, and Time (PRT) formula.
- The Principal is the amount that was initially borrowed from the bank or invested.
- The Rate is the interest at which the principal amount is given to someone for a certain time. The rate of interest is usually around 3% per annum.
- The duration for which the money is left in the account.
- To know the interest you’ll be getting, all three factors are multiplied.
For example, if your savings account pays 3% interest once a year and you placed N100,000 in it, you’d calculate the interest as N100,000 x .03 x 1 = N5,000 per annum.
How to Calculate Compound Interest on a Savings Account
Calculating compounding interest takes a more complicated formula.
The elements of compound interest are:
A = the total value in the future
P = the initial deposit
r = the interest rate
n = the number of compounding periods
t = the number of periods that have passed or will pass
To calculate compound interest on a savings account, you need to consider two aspects:
More frequent periodic interest payments
Many interest-bearing accounts pay interest more than once per year. For example, your bank might pay interest monthly.
An increasing account balance
Any interest payments will alter subsequent interest calculations.
Here, you add the assumption that your bank pays interest, which compounds monthly. Use this compound interest formula to calculate the ending amount after one year (A).
In this example where interest is compounded monthly, instead of earning 3% per year, you earn one-twelfth of three percent per month.
In the second month, you will earn the same 1/12% but you get to multiply it by the bigger balance:
At this point, you’re already earning interest on your interest.
If the calculation appears too cumbersome, nairaCompare has tools to help you through the process.
The more money you put into your savings account, the more it matters whether the account pays simple or compound interest. Compounding interest will help you hit each savings goal faster.
The vast majority of savings and money market accounts pay compound interest. Some certificates of deposit (CDs) earn simple interest.
Types of Savings Accounts
Interests bearing savings accounts come with different features, depending on what they’re designed to do.
Traditional or Regular Savings Account
Traditional savings accounts are what you may immediately think of when you consider where to save. These are the savings accounts you typically find at traditional banks or credit unions.
These kinds of accounts are good for people who need to save money for the short or long term and aren’t as concerned about getting the best interest rate.
These types of savings accounts generally allow you to earn interest on your money, although they usually pay lower rates than other savings products. Many banks and credit unions allow you to open a regular savings account with a low minimum deposit.
High-yield savings accounts
These are typically found at online banks, and online credit unions. They are savings accounts that offer a higher APY compared to regular savings accounts.
This is one of the best types of savings accounts to maximize your money’s growth.
Online banks often offer different types of high-yield savings accounts to attract savers who want to earn a better interest rate than what is found at brick-and-mortar banks and credit unions.
This type of savings account may be appealing if you’re comfortable managing your account via the website or mobile banking versus visiting a branch.
Money Market Accounts
Money market accounts (MMAs) combine the features of a regular savings account with the features of a current account. You can find these accounts at brick-and-mortar banks, online banks, and credit unions.
They are usually good for people who want to earn interest on savings while having more options for accessing their money.
These accounts, which may also be called money market savings accounts or MMSAs, allow you to earn interest on your savings.
Rates are typically better than regular savings accounts and some offer rates similar to high-yield savings accounts. You may also be able to write checks from your account or access funds with an ATM or debit card.
Certificates of Deposit (CDs)
Certificates of deposit (CDs) are time deposits, meaning you agree to leave your money in the account for a set period.
During that time, your money earns interest and, when the CD matures, you typically can withdraw your savings or roll it into a new CD.
That sets these accounts apart from other types of savings accounts since there’s a time factor at work.
It is usually good for those who want to earn competitive rates and won’t need to access their savings right away.
Cash Management Account
Cash management accounts are different from other types of savings accounts because they’re not specifically designed for saving.
Instead, these accounts let you hold the cash you may plan to invest in a taxable brokerage account or a retirement account.
Online brokerage platforms may offer cash management accounts to their investors. The money held in the account can earn interest, often at a higher rate than what you’d get at a bank.
Depending on the brokerage, you may get all the standard features you’d expect with a current account as well. For example, you may be able to write cheques, pay bills or transfer funds to accounts at your bank.
Specialty Savings Account
Specialty savings accounts are designed to help you reach specific savings goals, rather than being a catch-all for the money you don’t plan to spend.
In some cases, they can be intended for a specific type of person, rather than a savings goal.
For example, there are different types of savings accounts for minors. Three types of savings accounts you might set up on behalf of a child or teen include:
- Kids’ savings accounts
- Custodial savings accounts
- Student savings accounts
We have made it easy for you at nairaCompare with the right tools to calculate the interest on your savings account.