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How to earn interest on savings
Earning interest on savings is one way to grow money over time. When money is deposited into a savings account, the bank pays interest on that balance, which gradually increases the amount of money in the account.
There are important terms to understand about earning interest on savings. The first is interest rate, which is the percentage at which the money in the account earns interest; the higher the rate, the more money earned.
Compounding interest means that the interest earned also earns interest, and the more frequently it compounds (daily, monthly, or quarterly), the faster the savings grow.
The last is annual percentage yield (APY). APY represents the real rate of return earned on a savings account by including the effect of compounding interest.
Ways to earn interest on savings
There are multiple types of deposit accounts to earn interest on savings, each with its own benefits and considerations. Here are some common savings account types:
- High-yield savings accounts (HYSAs): HYSAs generally offer higher rates compared to traditional savings accounts. They provide easy access to funds while helping earn higher interest. An example of an HYSA is PayPal Savings1, which combines a current competitive rate of 4.30% APY2 with convenience, allowing for automatic transfers, the ability to set goals to allocate to, and easy access via the PayPal app.
- Certificates of deposit (CDs): CDs are time deposits with fixed terms and rates. They usually offer higher rates than regular savings accounts. However, withdrawing money before the CD matures typically incurs penalties. A CD ladder strategy involves holding CDs with different maturities to provide a steady access to funds while taking advantage of higher rates.
- Money market account (MMA) savings: MMAs tend to offer higher rates than traditional savings accounts and include features like limited check writing and debit cards. These accounts combine some aspects of savings and checking accounts, giving MMAs both earning potential and accessibility. However, these types of accounts may limit the number of certain kinds of transactions or require minimum deposit amounts.
Choosing a savings account option
When determining which savings method to incorporate into a budget, several factors should be considered, such as:
- Savings goals: Identify what kinds of goals one is saving for. Something like an emergency fund or sinking fund may be better suited for different kinds of savings accounts. With short-term goals, for example, one might look for an account that allows for easy withdrawals or liquidity while someone focused on longer term goals may be fine with something that allows less access.
- Desired access to funds: Consider how easily funds need to be accessed. HYSAs and MMAs provide easy access to money, whereas CDs restrict access until the term ends.
- Risk tolerance: Although most savings accounts are low risk, understanding the slight differences in risk can help. There may be various conditions that apply to different types of accounts and from different providers, so be sure to review all terms before making a choice.
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How much interest can someone earn on savings?
These are the factors that can influence interest earnings:
- APY: The APY represents the rate of return on a savings account, factoring in the effect of compounding. A higher APY means more interest earned.
- Initial deposit: The starting amount of money in the savings account. Larger initial deposits will generate more interest.
- Duration: The length of time the money stays in the account, accruing interest. The longer the duration, the more interest earned.
- Compounding frequency: How often interest is compounded (daily, monthly, or annually). More frequent compounding results in more interest earned.
Here's an example of how to calculate interest on a savings account:
Let’s say $5,000 is deposited into a savings account with an APY of 2%, compounded monthly.
- At the end of the first month, interest is earned on the $5,000 deposit. With a 2% APY, the monthly interest rate is about 0.167% (2% divided by 12 months). So, in the first month, the interest earned would be approximately $8.35.
- For the second month, interest is calculated on the new balance, which is $5,008.33. This means slightly more interest is earned in the second month.
- This process continues each month, with interest being calculated on the growing balance.
- By the end of one year, the balance would have grown to approximately $5,101.67, meaning the total interest earned over the year would be around $101.67.
Potential strategies to maximize interest earnings
To help maximize interest earnings on savings, consider these strategies:
- Look around for the best rates: Use online resources to compare accounts to find the best rates. Different financial institutions offer varying rates, so shopping around can help secure the highest possible return on savings.
- Maintain a minimum balance (if required): Some accounts require a minimum balance to avoid monthly maintenance fees. Ensuring the minimum balance is maintained helps avoid fees that can eat into interest earnings.
- Consider automatic transfers: Set up regular automatic transfers from a checking account to a savings account to automate savings.