The greatest power in the financial world may be compound interest. But whether compound interest can work in your savings account will depend on the interest rate. An interest rate of less than 1% won’t be able to achieve the kind of momentum you need to build significant wealth. For that, it’s important to understand how banks calculate interest on a savings account.
Below you’ll find everything from types of savings accounts to broader economic factors that affect how banks calculate interest rates. You’ll also find savings account risks to make the best decision for your financial situation.
How interest rates on savings accounts work
How banks calculate interest rates on a savings account goes beyond the types of savings accounts to encompass federal fund rates and the amount of funds in the account. Here’s how each of those factors can affect your savings account interest rate and how to calculate your savings rate:
Federal funds rate
The federal funds rate is set by the Federal Open Markets Committee (FOMC). The federal funds’ target rate — or fed funds rate — is designed to guide overnight lending among U.S. banks. The federal funds rate sets upper and lower limits. Currently, the federal funds rate is 4.5% to 4.75%. As the federal funds rate goes up, interest rates on savings accounts usually follow suit. Savings account interest calculation counts the federal funds rate as a primary factor.
Broader economic factors
The Federal Reserve will typically adjust interest rates based on economic activity, including supply and demand, and the actions of the Fed and commercial banks. Other broad economic factors that affect interest rates include the strength of the economy, inflation, and unemployment. Interest rates reflect the risk lenders and borrowers are willing to assume.
Type of bank or credit union
Banks and credit unions will often set their rates. Some banks or credit unions are known for higher savings rates on certain accounts, usually with a minimum deposit. Savings account interest calculation will take into account all the other points on this list as well as individual bank incentives and promotions.
Type of savings account
Different savings accounts offer different rates. High-yield savings accounts are a better option if you want to use the power of compound interest in your favor. Right now, regular savings accounts have an average interest rate of 0.06%. High-yield savings accounts interest rates currently range from 2.95% to 4.45%.
Other types of savings accounts to consider:
- Money market accounts
- Certificate of deposit (CD) accounts
- Cash management account
- Specialty savings accounts like kids’ savings accounts, custodial savings accounts, and student savings accounts
Be sure to find out whether your bank is using a formula to calculate monthly interest on savings accounts or the more common annual percentage yield (APY). Monthly interest can offer greater compound interest growth over time, depending on the interest rate.
Amount of funds in the account
Banks typically offer higher interest rates on accounts with larger deposits and longer terms, as they can earn more money from those accounts. Many high-yield savings accounts offer cash bonuses for large deposits, ranging from $20,000 to $100,000 or more.
Length of time
Savings account interest calculation may take into account the length of time the money is held in the account and also affects the rate of return. Generally speaking, savings accounts that require longer terms will have higher interest rates. This doesn’t usually apply to a regular savings account or a high-yield savings account where you can transfer money at any time.
However, for CD savings accounts, you’ll get a higher interest rate for longer terms. A 10-year CD will give a higher interest rate than a one-year CD. To take advantage of higher interest rates and avoid fees, you need to leave the funds in the account for a longer duration.
Compound interest is where you can accelerate the growth of your money. With compound interest, every time you earn interest on your savings, those funds are added to your principal, and you earn interest on more funds. Compound interest is an exponential equation, shown as a line curving upward. It may start slowly, but it builds momentum over time.
If you put $10,000 in a high-yield savings account with 4% interest, after one year you’ll have $10,400. In 30 years, you’ll have $32,433.98. If, in addition to the initial savings you add just $50 per month, you’ll have $66,084.94 on just $28,000 of contributions. See how much you can earn with the government’s compound interest calculator here.
Risks of investing in savings accounts
While savings accounts are a good choice for short-term savings goals like a mortgage down payment or next year’s vacation, they are not usually the best choice for long-term savings. This comes down to lower interest rates, a lack of diversification, and possible withdrawal limits. Here’s what you need to know about the downsides of savings account interest calculation:
Savings accounts today don’t offer the same competitive interest rates as 30 years ago. Your interest rate may be so low that it doesn’t keep up with inflation. In fact, for most savings accounts in the U.S., that is the case. From January 2022 to January 2023, prices increased by 6.4%. That means that even with a high-yield savings account, your money is losing value — spending power — over time.
With a standard savings account where the interest rate is less than 1%, even in times of low inflation the funds will lose spending power over time. That’s why savings accounts are good for short-term savings goals rather than long-term savings.
Some savings accounts have withdrawal restrictions. You may only be able to withdraw funds one to three times per month or may have a limit on the amount of money you can withdraw in a month without a penalty. If you need access to all the money quickly, be sure your savings account doesn’t impose limits or fees.
Lack of diversification
Besides savings account interest calculations, investing too much in a savings account can prevent you from exploring high-yield opportunities to grow your finances. For long-term financial growth, consider a diverse investment portfolio that matches your risk tolerance and employs principles like dollar-cost averaging and investing for the long term.
Consider stocks, bonds, mutual funds, CDs, and other investment tools to build a diverse investment portfolio. Along with a high-yield savings account and other types of savings accounts like CDs, you’ll be better equipped to balance long-term growth with security.
How To Calculate Savings Rate
The savings rate is the interest rate, compounded with the principal over time. But calculating savings rate is more than choosing a high-yield savings account with the greatest interest rate. Beyond the savings account interest calculation, you want to check withdrawal limits and current inflation rates and consider diversification.
Saving is also a financial strategy. Carefully consider your savings goals and choose a diverse set of savings tools, including high-yield savings accounts, CDs, investment accounts, and retirement accounts to build savings for both long-term and short-term goals.
How much interest would $1,000 make in a savings account in one year?
How much $1,000 will make in a savings account in one year will depend on the interest rate. With a high-yield savings account with a 3.4% interest rate, $1,000 will make $34 in one year.
How much interest will I earn in a savings account?
How much interest the savings account earns depends on the interest rate specified by the bank on the account type. It could be as little as 0.03% to 4% or more.
How do you calculate the total interest on a savings account?
To find the savings account interest calculation for the total interest on a savings account in a set period, the formula is:
Interest = principal (beginning balance) x interest rate x number of time periods
For example, for $1,000 in principal in a savings account paying 4% per year you can write:
$1,000 x .04 x 1 = $40 in interest in one year. For compound interest, you can use this calculator.