When you open a savings account, be sure to pay attention to how often interest is accrued. Specifically, a savings account that pays interest more frequently will end up paying you more than one that pays less frequently, even with the same interest rate. Here's what you need to know about how banks pay interest on savings accounts.
What are the options?Technically, a bank could choose to calculate and pay interest at any interval it wanted to. However, in practice, there are only a few methods of compounding interest that are actually used:
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- Annual compounding -- Interest is calculated and paid once a year.
- Quarterly compounding -- Interest is calculated and paid once every three months.
- Monthly compounding -- Interest is calculated and paid each month.
- Daily compounding -- Interest is calculated and paid every day.
Why does it matter?To illustrate why this matters, consider a simple example of a savings account with a 4% interest rate (wouldn't that be nice?). Now, compounded annually, a deposit of $10,000 would produce $400 in interest during the first year.
However, if the bank chose to compound quarterly, instead of paying 4% at the end of the year, interest would instead be paid at 1%, four times each year. So, after three months, an interest payment of $100 would be given. Now, after another three months, interest would be calculated at 1% of the new balance of $10,100, or $101. The cycle repeats in three more months, and so on. After a year, here's what the account looks like.
Sure, it's only $6.13 more than our annual compounding example, but it's still more money. In other words, a faster rate of compounding effectively makes an interest rate higher -- in our case 4.06% vs. 4%.
How can you calculate your savings account's interest?The general formula for determining the effects of compound interest is:
In the formula, "t" refers to the amount of time in years, "r" refers to the interest rate expressed as a decimal (so 4% would be 0.04), "n" is the number of times interest is compounded each year, and "P" is the principle, or the amount of money you start with. For example, if I put $10,000 in a savings account for five years at 4% interest compounded monthly, my account balance would be:
What do banks actually do?It depends on the bank. Most banks pay interest monthly, but the compounding interval can vary. Just to name a few examples, Bank of America and Wells Fargo compound interest daily. Chase, on the other hand, compounds and pays monthly. The best way to find out how often your savings interest is calculated is to check with your bank.
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