If you have a savings account, you might want to know how much you’ll earn in interest for parking your cash there. Fortunately, calculating interest on a savings account is not as tough as you might think.
[Read: Best Savings Accounts.]
Types of Savings Account Interest
Account holders will come across two types of interest on savings — simple interest and compound interest:
— Simple interest refers to the interest earned only on the initial deposit in a savings account. So, if your initial deposit was $500, the simple interest would be calculated based on that amount.
— Compound interest refers to the interest earned on both the initial deposit in a savings account and the interest that accrues. For example, if your initial deposit was $500, the compound interest would be calculated based on that amount plus the amount of accumulated interest. Most savings accounts compound interest.
Compound interest beats simple interest in terms of how much money you can build up in a savings account. That’s because compound interest is “interest on interest.” Over the long run, you can generate wealth more quickly if your money is in a compound interest savings account than in a simple interest savings account.
Take a look and see how compound interest can really grow your savings.
How Does Compound Interest Work?
Savings accounts earn compound interest on a daily, monthly, quarterly or annual basis. If interest is compounded daily, it’s calculated and added to your balance each day. This results in more earned interest than if the interest is calculated and added monthly, quarterly or annually.
The formula for calculating daily compound interest is A = P(1 + r/n)^nt.
— A is the amount of money you’ll wind up with.
— P is the principal or initial deposit.
— r is the annual interest rate (shown in decimal format).
— n is the number of times the interest compounds in a year.
— t is the number of years.
Let’s say your initial deposit is $1,000, interest is compounded daily at a rate of 4% and the time period you’re looking at is five years.
This is how the formula would look in that scenario:
1,221.39 = 1,000(1 + .04/365)^365×5
Therefore, a $1,000 initial deposit in an account with compound daily interest at a rate of 4% would result in a $1,221.39 balance after five years.
Since most savings accounts compound interest on a monthly basis, here’s how that formula would work.
1,221 = 1,000(1 + 0.4/12)^12×5
Based on monthly compounding, the same initial deposit ($1,000) earning the same interest rate (4%) would lead to a balance of $1,221 after five years. That’s 39 cents less than the five-year amount based on the daily compounding formula.
Now, let’s look at annual compounding using the same numbers.
1,216.65 = 1,000(1 + 0.4/1)^1×5
As you can see, annual compound interest at a rate of 4% would give you measurably less money ($4.35 less) after five years than monthly compounding.
How Does Simple Interest Work?
The formula for calculating simple interest is A = P x R x T.
— A is the amount of interest you’ll wind up with.
— P is the principal or initial deposit.
— R is the annual interest rate (shown in decimal format).
— T is the number of years.
Here’s how the simple interest formula looks if the initial deposit is $1,000, the annual interest rate is 4% and the number of years is five.
200 = 1,000 x .04 x 5
This means over the course of five years, you’d earn $200 in simple interest. Coupled with the initial deposit, your account balance would be $1,200. Therefore, you’d end up with less money than if your account offered compound interest.
[Read: Best CD Rates.]
When Compound Interest Works Against You
Though compound interest works in your favor in terms of saving money, it works against you when you’re borrowing money.
If compound interest is calculated for a credit card, for example, it can increase the cost of borrowing money.
You can avoid paying interest on credit cards if you pay your balance in full before each monthly due date. However, if you carry a balance from one month to the next, your interest charges will keep growing.
Typically, credit card issuers charge compound interest daily (known as the daily periodic rate) and add that interest to the balance. The interest rate for a credit card is expressed as annual percentage rate.
You can figure out the DPR by dividing the APR by 360 or 365, depending on the formula used by your credit card issuer. So, if your APR is 20% and the card issuer uses 365 in its DPR formula, the DPR would be 20% ÷ 365 = 0.054%.
To get a better handle on what compound interest means for your credit card debt, divide the APR by 12 to compute the monthly percentage rate. Then multiply that rate by the average daily balance to arrive at your estimated interest charges for the month.
The formula would be:
APR/12 x average daily balance = monthly interest charges
So, if the credit card APR is 20%, the monthly percentage rate is 1.66% (20/12 = 1.66) and the average daily balance is $2,500, your estimated monthly interest charges would be $41.50 (0.0166 x 2,500 = 41.50).
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How to Calculate Savings Account Interest originally appeared on usnews.com
Update 09/05/24: This story was previously published at an earlier date and has been updated with new information.
