How savings account interest works

It may come as no surprise that a savings account is a good place to store your money, especially when interest rates are high.

So, how does savings account interest work? Fair question. It’s one that puzzles many. Yet understanding how interest works on a savings account is an important part of maximizing your hard-earned dollars.

Here’s an overview of how savings account interest works to get you started:

Interest is the cost of borrowing money. Generally, you’ll pay interest to borrow money, and you can collect interest when you lend money.

But who’s going to pay you to borrow your money? For many people, opening a savings account is one of the easiest ways to go about this. When you put money in a savings account, the bank is technically borrowing the money and paying you interest in return.

“The bank determines the rate, although it’s affected by the general level of rates in the economy and whether the bank is trying to attract new deposits,” says Liz Weston, CFP®, columnist at a personal finance website.

You can start earning more with one of the best savings rates in America when you open a Capital One 360 Performance Savings account.

Keep in mind that the interest rate determines how much money a bank pays you to keep your funds on deposit. However, Michael Griffin, a certified public accountant and finance lecturer at a college, says you should use the annual percentage yield (APY) to compare savings accounts and other savings products.

“The simple way to look at the APY—it’s what you will get on your money,” Griffin says. Meaning, you can use the APY to determine how much you’ll actually earn in interest each year. That’s because the APY relies on two things: the interest rate and how often the interest compounds. Both are important components of how interest works on a savings account because they impact how much money you’ll earn over time. Your savings account interest could compound daily, monthly, quarterly or annually. Here’s how compounding works.

Suppose that:

• You deposit $5,000 into a savings account.

• You don’t deposit any more money.

• You don’t withdraw any of your money.

• The interest rate doesn’t change.

Say that the account has a 1.00% interest rate and the interest compounds annually—that is, the bank pays you interest on your balance once each year. In this case, you’ll earn $50 after the first year. The APY will also be 1.00% in this example because your interest didn’t compound multiple times during the year.

But here’s where compounding gets interesting. In year two, you don’t just earn interest on your original $5,000. You earn interest on $5,050. And in year three, on $5,100.50. The amounts seem small at first, but over 10 or 20 years, that snowball effect can add up to much more than you’d earn without compounding. That’s the real power of APY.

If a bank offers a 1.00% interest rate on a savings account, the rate of compounding could affect the APY and your earnings. Keep in mind that the differences may only be minor.

When interest rates are low, there isn’t a huge difference on smaller balances. However, your earnings can increase over time. That's especially true if your savings account offers a higher interest rate and APY and you make regular deposits.

Luckily for savers, many banks offer savings accounts with interest that compounds daily or monthly, rather than annually.

You might wonder, what are some of the best savings interest rates? Different institutions offer their own interest rates, with rates that start at 0.01%. This means that an answer to the question, “How much interest does a savings account earn?” largely depends on which savings account you’ve chosen. For example, you can earn one of the top savings rates in America with a high yield Capital One savings account.

Understanding how interest works on a savings account is a key step in managing your money. Comparing the APY offered by several banks can also help you decide where to open an account.

It can be a smart idea to research banks with no monthly fees since overdraft fees can add up. These fees could offset your interest earnings or even cost you more than you earn. Other potential expenses include fees for bank checks or wire transfers.

Capital One 360 Performance Savings accounts are fee-free. Add in no minimum balance requirements and you have more money in your wallet.

So, what is interest on a savings account? Now that you’ve seen how savings account interest works and understand how much interest a savings account earns, you can put your new knowledge to work. 

Having a savings strategy can help you meet your goals. For example: a new car, a vacation or your emergency fund. Give your savings account some real growth with a great rate that helps every dollar go further.

Weston says to “set up as many accounts as you like and name them for different goals: vacation, holidays, property taxes and so on.” Separating your funds into multiple savings accounts designed for specific purposes can make it easier to resist temptation to spend your money. As a result, you could reach your financial goals sooner. It’s easy to start saving when there’s no minimum balance required. You can open a 360 Performance Savings account with any amount.

If you want to focus all your efforts in one place, another option is to have one account where you keep all your savings. You could then use a spreadsheet to categorize your funds. This can help you organize them by bills, expenses or financial goals.

These are just two examples. Have a different idea about how to manage your savings? Try it out. As long as you’re progressing toward your goals and using your understanding of how savings account interest works, you’re headed in the right direction.

To get the most out of your savings, look beyond the interest rate. APY tells you what you’ll actually earn once compounding is factored in. Over time, that difference can be significant and your 360 Performance Savings account can grow faster. Pair a high-yield account with regular deposits, and your savings can grow faster than you might expect.

Now that you know more about how savings account interest works, consider how Capital One’s easy online process lets you open a 360 Performance Savings account from your couch in about 5 minutes.