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When you open a savings account, your bank will most likely give you an interest rate that will be paid on money you have deposited. But how exactly does this work? Is this rate the interest you'll get every month or every year? How often will interest show up in your account?
In this article, we'll go through the important details of how savings account interest works and what you should know about it.
The short answer is that your savings account interest rate is expressed on an annual basis. However, the complete answer to the question of whether your savings interest rate is paid monthly or yearly is a little more complicated than it sounds.
There are three different interest rate concepts you should know in regard to your savings account:
Annual percentage yield is the technical term for the "interest rate" your bank probably tells you or advertises for your savings account. And although the terms APY and interest rate are often used interchangeably, they actually mean slightly different things, which we'll get to in the next definition.
In simple terms, your APY is the yield you would get on your money after one year. As an example, let's say you deposit $1,000 into a savings account with a 4% APY. After one year, you can expect to have $1,040. Of course, this assumes you don't deposit or withdraw any money, and that your APY stays constant for the entire year, both of which aren't likely in real-world situations.
Because savings accounts typically express their interest as APY (with the "A" standing for "annual"), the short answer to our question is that your savings account interest rate is yearly.
It's also worth mentioning that savings account APYs vary significantly between financial institutions. Some of the best-known branch-based banks pay some of the lowest APYs on savings accounts, even in the rising-rate environment we're in. On the other hand, some of the top online banks pay much more. This is why it pays to shop around before you open a savings account, as you might be surprised by the difference in rates paid by different banks.
Here's where APY and interest rate differ. APY takes into account how often your interest is calculated by the bank. Interest rate does not.
As a simplified example, let's say your personal savings account has a 3% interest rate and your interest is compounded monthly. This means that instead of your bank calculating your interest once per year at 3%, it will calculate it once per month at one-twelfth of that rate, or 0.25% in this case.
The reason APY is different is a little mathematically complex, but here's the idea. If you have $1,000 in an account at 3% compounded monthly, after one month you'd have $1,002.50. When your second month's interest is calculated, it is based on that new higher amount, not the original $1,000.
Each month, the balance used to compute your interest gets higher. Your interest is then calculated on your original principal plus the interest that has accumulated so far. APY takes this effect into account. I'll spare you the math, but in this example, a 3% interest rate compounded monthly translates to a 3.04% APY. As mentioned, they are slightly different concepts.
The compounding frequency of savings account interest depends on your bank. Monthly or quarterly compounding are the most common, but other frequencies, such as daily compounding, aren't unheard of.
Finally, payment frequency is how often the interest you've earned actually shows up in your savings account. And this isn't necessarily the same as compounding frequency. For example, it's entirely possible for a savings account to compound interest on a daily basis and pay interest monthly. Most savings accounts pay interest on a monthly basis, regardless of compounding frequency, although there are exceptions.
We'll look at an example of how savings account interest is calculated, but here's the mathematical formula:
In this formula, "r" stands for the interest rate, "n" stands for the number of compounding periods each year, and "t" is the amount of time in years. For monthly compounding, "n" is 12, and one month is equal to 0.833 years.
For example, let's say that you open a savings account that pays 2.5% interest compounded and paid monthly. You deposit $5,000, and your balance remains the same for the entire first month. Here's how your first monthly interest payment would be calculated. Note that in the formula, percentages need to be converted into decimals.
The difference between the final and initial balance is the amount of interest your account earned over the time period, which is $10.42 in this case.
It's important to realize that unless your savings account is actually a certificate of deposit, or CD, your interest rate or APY won't be constant over time. Financial institutions can choose to increase or reduce your savings account interest rate periodically, which is a big part of how savings accounts work. There's no way to know how often your interest rate could change, or by how much. Savings account interest rates aren't usually dependent on any benchmark interest rate and are set by the financial institution.
Having said that, savings interest rates tend to move in the same direction as benchmark interest rates, particularly the federal funds rate. When the Federal Reserve raises its rate, financial institutions often increase the rates they're willing to pay on savings deposits. In 2023, we've seen the rates paid by the top high-yield savings accounts generally trend higher because of the Federal Reserve's rate hikes.
We recommend comparing high-yield savings account options to ensure the account you're selecting is the best fit for you. To make your search easier, here's a short list of standout accounts.
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up to 4.60%Rate info You can earn the maximum APY by having Direct Deposit (no minimum amount required) or by making $5,000 or more in Qualifying Deposits every 30 days. See SoFi Checking and Savings rate sheet at: https://www.sofi.com/legal/banking-rate-sheet.
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4.35%Rate info 4.35% annual percentage yield as of February 26, 2024
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In most cases, savings account interest is paid monthly. There can be exceptions -- for example, some banks make quarterly payments.
The interest paid on savings accounts is compound interest, although the frequency at which it compounds can vary. The short definition of compound interest is interest that is paid on the principal balance and the interest that has accumulated in the account. This is the primary reason that a savings account's interest rate and APY (annual percentage yield) are typically two different numbers. APY takes the effects of compounding into account, while interest rate doesn't.
The amount you'll make on a $1,000 savings account deposit depends on your account's APY and how long you leave your money in the account. As an example, let's say you deposit $1,000, your bank pays a 3% APY, and you leave your money in the account for three years. After the first year, you'd have $1,030. After the second, that amount would grow by 3% to $1,060.90. And after the third year, your balance would grow by another 3% to $1,092.73.
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