J18) How to find the rates of returns on your checking/savings account?

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Today We Will Talk About the How to find the rates of returns on your checking/savings account?

Interest earned on savings is the money earned when you place it in a savings account. It's important to know how to calculate it, so you can compare the savings accounts from different banks and find the one that will work for you while it helps your money grow.

When you place money in a savings account, your bank pays you interest. Interest earned on savings is added back into the account every period; this amount becomes your new balance. When the next period ends, interest on that new balance is added to your account. This is compounding interest, one of the fundamental principles behind using your money as a tool to help you grow financially.

Learn how to calculate simple interest, compound interest, and use the annual percentage yield rate on a savings account.

How to Calculate Simple Interest Earned on Savings

To calculate interest earned on savings for one period, you'd use this formula:

Interest = Principal x Rate x Number of Periods

For example, if your savings account paid 5% interest once a year and you placed $100 in it, you'd calculate the interest as $100 x .05 x 1 = $5.

The interest you've earned on your savings is paid because your bank borrows money from you when you place it in your savings account; it also acts as an incentive to keep your money in a savings account.

To calculate the interest earned from your savings account, gather the following pieces of information:

Principal: This is your account balance at the amount you lend to the bank.

Interest payment frequency: This is how often the bank pays you interest (yearly, monthly, or daily, for example).

Interest rate: This is the percentage that the account pays you.

Term: This is the overall length of the loan. You'll need to convert months to years for this variable. For example, one month is .083 years, two months equals .167 years, and 18 months equals 1.5 years.

Once you have the information, you can plug it into the simple or compound interest formulas to figure out the interest earned on your savings. For example, the interest you earn on your savings in one period is simple interest.

How to Calculate Compound Interest on a Savings Account

Interest on savings accounts is expressed in percentage terms. For example, let's say you have $1,000 in the bank; the account might earn 1% interest. Unfortunately, most banks pay less than 1% interest on savings accounts due to historically low-interest rates.

Interest on Interest

In performing a straightforward interest calculation, $1,000 that earned 1% interest in one year would yield $1,010 (or .01 x 1,000) at the end of the year. However, that calculation is based on simple interest, paid only on the principal or the deposited funds. Some investors, such as retirees, might withdraw the earned interest or transfer it to another account. The interest payments act as a form of income. If the interest is withdrawn, the depositor's account will earn simple interest since no interest would be earned on any past interest.

However, with interest rates being so low, many depositors may opt to leave the interest earned in their savings account. As a result, the money in the savings account would earn compound interest, where the interest is calculated based on the principal and all of the accumulated interest.

The Power of Compounding Interest

In savings accounts, interest can be compounded, either daily, monthly, or quarterly, and you earn interest on the interest earned up to that point. The more frequently interest is added to your balance, the faster your savings will grow. Using our $1,000 example earlier and applying daily compounding every day, the amount that earns interest grows by another 1/365th of 1%. At the end of the year, the deposit has grown to $1,010.05 versus $1,010 via simple interest.

Of course, an extra $0.05 doesn't sound like much, but at the end of 10 years, your $1,000 would grow to $1,105.17 with compound interest.

 The 1% interest rate, compounded daily for 10 years, has added more than 10% to the value of your investment.

Again, the amount earned still might not seem like much, but consider what would happen if you could save $100 a month and add it to the original $1,000 deposit. After one year, you would have earned $16.05 in interest, for a balance of $2,216.05. After 10 years, still adding just $100 a month, you would have earned $725.50, for a total of $13,725.50.

Although the amount is not a fortune, it's a reasonably-sized rainy-day fund, which is one of the main purposes of a savings account. When money managers talk about "liquid assets," they mean any possession that can be turned into cash on demand. It is, by definition, safe from fluctuations in the stock market and real estate values. In real-people terms, it's an emergency fund that can be used for unexpected expenses such as medical bills or car repairs.

The Snowball Effect

To truly understand the snowballing effect of compound interest, consider this classic test case, conducted by none other than Benjamin Franklin. The scientist, inventor, publisher, and Founding Father was a bit of a showman, so it must have given him a chuckle to launch an experiment that would not bear results until 200 years after his death in 1790.

In his will, Franklin left roughly the equivalent of $4,500 each to the cities of Boston and Philadelphia. He stipulated that it was to be invested at 5% annual interest for 100 years. Then, three-quarters of it were to be spent on a worthy cause while the remainder was to be reinvested for another 100 years.

In 1990, Boston's fund had about $4.5 million while Philadelphia's fund had about $2.5 million due to the effects of compound interest.

 However, neither city came close to the combined $21 million that Franklin calculated they would achieve. The reason is that interest rates fluctuate over time, rarely achieving the 5% annual rate that Franklin assumed.

Start Early, Save Often

Still, Franklin's experiment demonstrated that compound interest can build wealth over time, even when interest rates are at rock bottom. It's quick and easy to find the current rates banks are offering by going online. Some banks specialize in high-yield savings accounts. The best savings accounts include those offered by banks where interest on the account is compounded daily, and no monthly fees are charged. Banks often state their interest rates as annual percentage yield (APY), reflecting the effects of compounding. Note that the APY and annual percentage rate (APR) are not the same, for APR doesn't include compounding. 

What's compound interest compared with simple interest?

Compound is interest on your interest, or reinvesting accumulated interest from previous periods. Simple interest is paid only on the principal or the deposited funds.

What's the long-term benefit of compounding?

Investors can use the concept of compounding interest to build up their savings and create wealth. If you reinvest the interest you earned on your savings account and the initial amount deposited, you'll earn even more money in the long term.

The Bottom Line

Unlike Benjamin Franklin, most of us have no desire to test what our savings might be worth in 200 years. But we all need to have a little money set aside for an emergency. Compound interest, combined with regular contributions, can add up to a decent emergency nest egg.

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Free money doesn’t come along often, but with a savings account, it typically arrives once a month. That’s because banks pay you interest for keeping money in a savings account. But how much interest can you earn?

While the answer varies depending on your financial institution and a few other factors, knowing how to calculate interest on a savings account can help you estimate your earnings wherever you decide to save your money.

The easiest way to understand interest is to consider it as the cost of borrowing or lending money. You pay interest on an auto loan or mortgage when you borrow. But when you put your money into an interest-bearing savings or money market account, you’re essentially lending your money to the bank.

The bank uses your money and pays you interest. It lends the money “borrowed” from you to other customers for auto loans, personal loans and more.

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