How Does Interest Work?
Interest is the fee for using someone else’s money. When a person borrows money from a bank, the bank charges them interest (also expressed as an APR, or annual percentage rate). When a person stores money with a bank, the bank pays them interest (also known as APY, or annual percentage yield).
With a savings account, interest usually accrues daily or monthly and is paid at the end of the month. Let’s say you deposit $5,000 in a savings account with 1% interest that compounds daily. At the end of day one, your savings would grow by 1/365 of 1%, or 13.6986c, and you would now have $5,000.136986 (or $5,000.14 after rounding up the cents column).
Celebrated investor Warren Buffett famously said that his “wealth has come from a combination of living in America, lucky genes, and compound interest.” By compound interest, he was referring to the phenomenon of earning interest on interest. Let’s go back to our example. On day one, you earned interest on $5,000. On day two, you would earn 1/365 of 1% interest on $5,000.136986, which is 13.7005. Read this last sentence closely and you’ll notice you earned 0.0019c more on day two than you did on day one.
This might not seem like a big deal, but keep on earning compound interest over months and years and it starts to make a huge difference. In year one, you’d earn $50.25 interest, in year two $50.76, and by year five $52.30. The more you deposit in your savings account and the higher the interest rate, the more interest you earn.
Why Do Banks Pay Interest?
When considering a savings account, you may well ask: What’s the catch? or, What does the bank want in return? The answers are: there is no catch, and all the bank wants in return is for you to deposit as much money as possible for as long as possible.
Banks make a small amount from fees, but their primary source of revenue is using deposits from some customers to lend money to others. Ever wondered why banks charge more for loans than they give to depositors? That’s because the difference between the rates is their profit margin. Let’s say the bank pays you 1% interest on $200,000 of savings and charges 5% interest to someone else for a $200,000 loan. The bank earns 4% annual interest on $200,000, plus/minus other fees and costs.
Are Savings Accounts Safe?
People with memories of the 2008 financial crisis might naturally be suspicious toward banks. In the years following the crisis, hundreds of banks became insolvent and a portion were unable to pay the full funds owed to depositors. In 2018, the banking sector returned to full health and not one bank declared insolvency.
In the wake of the financial crisis, the US Government raised the Federal Deposit Insurance Commission’s insurance limit from $100,000 to $250,000 and put in place new rules to ensure the FDIC always has sufficient reserves to be able to cover all depositors in times of crisis. Today, all depositors are insured for at least $250,000 at each bank where they have an account. Joint accounts offer even greater protection, with a $500,000 limit.
There is no such thing in life as a 100% iron-clad, risk-free place to store your money. However, compared to investments like stocks, bonds, and property, savings accounts come with far lower risk and a far lower minimum deposit. Savings accounts are also safer than just storing the money under your mattress and they offer higher yields. (In fact, storing money under the mattress actually loses money over time, because the value of money increases through inflation while the money stored under your mattress won’t earn you a cent).
How to Open an Online Savings Account
One of the great things about online banks is that they let you apply for and open a savings account from home. Just fill out a few details about yourself to open an account, wire in an initial deposit, set up a recurring deposit, and check in every so often to see how much you’re earning.
Online banks have grown in popularity in recent years, and all this competition is great news for consumers. Before opening a savings account, don’t forget to do a comparison. We recommend comparing online savings accounts by APY, fees, minimum requirements, customer service, and other features, such as whether they offer a hybrid checking-savings account.
Of course, the most important thing to compare is the APY, or annual percentage rate. Today’s APYs vary from as little as 0.01% to as high as 2.25%. The higher the rate, the greater the likelihood that there are minimum requirements such as a minimum balance attached. Before going for a high rate, don’t forget to double check what’s required of you.