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How banks can pay interest on your money

How banks can pay interest on your money


Uncategorized

How banks can pay interest on your money

A bank account’s APY tells you how much interest your money will earn in a given year. FG Trade/Getting Images Personal Finance Insider writes about products, strategies, and tips to help you make smart decisions with your money. We may receive a small commission from our partners, like American Express, but our reporting and recommendations…

A bank account’s APY tells you how much interest your money will earn in a given year.

FG Trade/Getting Images


Personal Finance Insider writes about products, strategies, and tips to help you make smart decisions with your money. We may receive a small commission from our partners, like American Express, but our reporting and recommendations are always independent and objective.

  • Most bank accounts use compound interest formulas, compounding daily, weekly, monthly, or according to some other rate of frequency.
  • The annual percentage yield (APY) shows how much interest your money will earn in a given year, including all compound interest.
  • When comparing bank accounts, it’s important to look at the APY that each offers in addition to other factors such as branch/ATM availability and fees.
  • See Business Insider’s picks for the best high-yield savings accounts »

Thanks to government protections, a bank account is one of the safest places to store your hard-earned money. But security isn’t the only benefit of a bank account. Most banks will pay you interest on the money you deposit as well. 

To be clear, savings accounts, money market accounts, and CDs, aren’t likely to yield as high of a return as riskier options, like stock market investments. But, depending on the amount that you deposit and the bank account’s APY, you can still earn a significant chunk of change while maximizing safety and liquidity.

Let’s take a closer look at how bank account interest works and discuss what you should focus on when comparing accounts.

How does interest work on bank accounts?

Before we get into explaining how interest works on bank accounts, it’s important to understand why banks pay interest in the first place. After all, if your money is “just sitting” in your account, how can a bank afford to pay you interest on the funds?

The answer is that banks use a percentage of their bank deposits to make loans, like mortgages, business loans, or credit cards. So, in essence, you’re lending money to your bank; in turn, your bank lends it out again at a higher rate. The bank makes money by charging higher interest rates on its loans than it pays on its deposit accounts (savings accounts, CDs, etc).

Does this setup mean that you could try to withdraw your money from your bank account one day only to discover that it’s not available? Most likely not. For years, banks have been required to keep at least 10% of their total deposits as liquid cash and most have built up ample reserves. And, even in the unlikely event that your bank was to fail, FDIC insurance protects your deposits up to $250,000.

Do bank accounts use simple or compound interest formulas?

With simple interest, a 2% interest rate on $10,000 would net you $200 per year. But banks don’t typically calculate interest in this way. Instead, most banks use compound interest formulas, with the frequency of compounding varying by bank. Some accounts compound daily, while others follow a weekly, monthly, or other compounding schedule.

Let’s say that a bank savings account pays 2% interest, compounded daily. Instead of receiving a flat 2% interest payment at the end of the year, you’d earn 1/365th of that 2% per day. And each day that 1/365th interest accrual would be slightly larger because it would be based on a slightly higher balance.



Clint Proctor


On a $10,000 balance, that daily compounding would result in an extra $2 of interest at the end of the first year. That may not sound too exciting. But imagine that you allowed the money to compound for 20 years.

With simple interest, you would earn $4,000 in interest over 20 years for an ending balance of $14,000. But with daily compounding interest, your account would be worth $14,918 at the end of the 20 years. That’s nearly an extra $1,000 that you would have earned thanks to the power of compound interest alone.



Clint Proctor


What’s the difference between a bank account’s interest rate and APY?

Due to the effects of compounding, the actual rate of return that you earn on your bank account will be slightly higher than its interest rate. To help customers determine what they’ll actually earn in a year’s time, many banks publish a different number called the annual percentage yield (APY).

A bank account’s APY tells you how much interest your money will earn in a given year, including all compound interest. An account’s compounding frequency will affect how much the interest rate varies from the APY.

For example, if a bank account paid interest annually, the interest rate and APY would be the same. If interest compounds monthly, the APY will be slightly higher than the interest rate. And the APY would be even higher if the interest compounded daily.

For these reasons, a bank account’s APY is the key number that you want to focus on. Thankfully, most banks publish APY rates rather than interest rates, so this shouldn’t be something you need to calculate on your own. But if you’d like to know how, the FDIC offers an APY mathematical formula.

Which bank accounts offer the highest APY?

According to the FDIC, the average savings account pays a paltry 0.06% APY. However, it’s likely that you can earn a much better return by simply taking the time to shop around. 

If you’re comfortable with using online banks, this may be a good place to start your search. With no physical branches to maintain, digital banks are able to save money on overhead. Many, in turn, pass those savings along to their customers in the form of higher rates on their deposit accounts.

That’s not to say that full-service banks never offer competitive interest rates on their savings accounts, money market accounts, or CDs. A large bank, for example, may still offer a high-yield savings account as a means of differentiating itself from its competitors and attracting new customers. 

The bank that offered the best APY yesterday may not be the bank with the best rate today. That’s why it’s important to look at the most up-to-date information when you’re shopping for a bank account. 

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To make things easy for you, we’ve compiled a list of the top high-yield savings accounts available right now. Check out the list to compare APYs and to see what additional features and benefits each bank currently offers.

Disclosure: This post is brought to you by the Personal Finance Insider team. We occasionally highlight financial products and services that can help you make smarter decisions with your money. We do not give investment advice or encourage you to adopt a certain investment strategy. What you decide to do with your money is up to you. If you take action based on one of our recommendations, we get a small share of the revenue from our commerce partners. This does not influence whether we feature a financial product or service. We operate independently from our advertising sales team.

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Uncategorized

How banks can pay interest on your money

A bank account’s APY tells you how much interest your money will earn in a given year. FG Trade/Getting Images Personal Finance Insider writes about products, strategies, and tips to help you make smart decisions with your money. We may receive a small commission from our partners, like American Express, but our reporting and recommendations…

A bank account’s APY tells you how much interest your money will earn in a given year.

FG Trade/Getting Images


Personal Finance Insider writes about products, strategies, and tips to help you make smart decisions with your money. We may receive a small commission from our partners, like American Express, but our reporting and recommendations are always independent and objective.

  • Most bank accounts use compound interest formulas, compounding daily, weekly, monthly, or according to some other rate of frequency.
  • The annual percentage yield (APY) shows how much interest your money will earn in a given year, including all compound interest.
  • When comparing bank accounts, it’s important to look at the APY that each offers in addition to other factors such as branch/ATM availability and fees.
  • See Business Insider’s picks for the best high-yield savings accounts »

Thanks to government protections, a bank account is one of the safest places to store your hard-earned money. But security isn’t the only benefit of a bank account. Most banks will pay you interest on the money you deposit as well. 

To be clear, savings accounts, money market accounts, and CDs, aren’t likely to yield as high of a return as riskier options, like stock market investments. But, depending on the amount that you deposit and the bank account’s APY, you can still earn a significant chunk of change while maximizing safety and liquidity.

Let’s take a closer look at how bank account interest works and discuss what you should focus on when comparing accounts.

How does interest work on bank accounts?

Before we get into explaining how interest works on bank accounts, it’s important to understand why banks pay interest in the first place. After all, if your money is “just sitting” in your account, how can a bank afford to pay you interest on the funds?

The answer is that banks use a percentage of their bank deposits to make loans, like mortgages, business loans, or credit cards. So, in essence, you’re lending money to your bank; in turn, your bank lends it out again at a higher rate. The bank makes money by charging higher interest rates on its loans than it pays on its deposit accounts (savings accounts, CDs, etc).

Does this setup mean that you could try to withdraw your money from your bank account one day only to discover that it’s not available? Most likely not. For years, banks have been required to keep at least 10% of their total deposits as liquid cash and most have built up ample reserves. And, even in the unlikely event that your bank was to fail, FDIC insurance protects your deposits up to $250,000.

Do bank accounts use simple or compound interest formulas?

With simple interest, a 2% interest rate on $10,000 would net you $200 per year. But banks don’t typically calculate interest in this way. Instead, most banks use compound interest formulas, with the frequency of compounding varying by bank. Some accounts compound daily, while others follow a weekly, monthly, or other compounding schedule.

Let’s say that a bank savings account pays 2% interest, compounded daily. Instead of receiving a flat 2% interest payment at the end of the year, you’d earn 1/365th of that 2% per day. And each day that 1/365th interest accrual would be slightly larger because it would be based on a slightly higher balance.



Clint Proctor


On a $10,000 balance, that daily compounding would result in an extra $2 of interest at the end of the first year. That may not sound too exciting. But imagine that you allowed the money to compound for 20 years.

With simple interest, you would earn $4,000 in interest over 20 years for an ending balance of $14,000. But with daily compounding interest, your account would be worth $14,918 at the end of the 20 years. That’s nearly an extra $1,000 that you would have earned thanks to the power of compound interest alone.



Clint Proctor


What’s the difference between a bank account’s interest rate and APY?

Due to the effects of compounding, the actual rate of return that you earn on your bank account will be slightly higher than its interest rate. To help customers determine what they’ll actually earn in a year’s time, many banks publish a different number called the annual percentage yield (APY).

A bank account’s APY tells you how much interest your money will earn in a given year, including all compound interest. An account’s compounding frequency will affect how much the interest rate varies from the APY.

For example, if a bank account paid interest annually, the interest rate and APY would be the same. If interest compounds monthly, the APY will be slightly higher than the interest rate. And the APY would be even higher if the interest compounded daily.

For these reasons, a bank account’s APY is the key number that you want to focus on. Thankfully, most banks publish APY rates rather than interest rates, so this shouldn’t be something you need to calculate on your own. But if you’d like to know how, the FDIC offers an APY mathematical formula.

Which bank accounts offer the highest APY?

According to the FDIC, the average savings account pays a paltry 0.06% APY. However, it’s likely that you can earn a much better return by simply taking the time to shop around. 

If you’re comfortable with using online banks, this may be a good place to start your search. With no physical branches to maintain, digital banks are able to save money on overhead. Many, in turn, pass those savings along to their customers in the form of higher rates on their deposit accounts.

That’s not to say that full-service banks never offer competitive interest rates on their savings accounts, money market accounts, or CDs. A large bank, for example, may still offer a high-yield savings account as a means of differentiating itself from its competitors and attracting new customers. 

The bank that offered the best APY yesterday may not be the bank with the best rate today. That’s why it’s important to look at the most up-to-date information when you’re shopping for a bank account. 

Real Life. Real News. Real Voices

Help us tell more of the stories that matter

Become a founding member

To make things easy for you, we’ve compiled a list of the top high-yield savings accounts available right now. Check out the list to compare APYs and to see what additional features and benefits each bank currently offers.

Disclosure: This post is brought to you by the Personal Finance Insider team. We occasionally highlight financial products and services that can help you make smarter decisions with your money. We do not give investment advice or encourage you to adopt a certain investment strategy. What you decide to do with your money is up to you. If you take action based on one of our recommendations, we get a small share of the revenue from our commerce partners. This does not influence whether we feature a financial product or service. We operate independently from our advertising sales team.

LoadingSomething is loading.

More:

Compound Interest
Savings Account
CDs
Interest Rate

Chevron iconIt indicates an expandable section or menu, or sometimes previous / next navigation options.

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We hate SPAM and promise to keep your email address safe

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