Living on a purely cash-only basis is a thing of the past, not only because it’s much safer to keep your cash in a bank account, but also since most banks now offer several convenient methods to transact and maintain control over your funds. Yup, the primary feature of savings accounts (as opposed to checking accounts) is that they always earn interest. But how do interest rates work? How do they affect your savings?
Simple. Just think of a savings account as a VIP parking space for your cash, that allows you to grow the money that you don’t intend to spend on a regular basis.
How does interest work on a savings account?
Savings accounts are one of the most basic banking services: in exchange for allowing banks to invest the funds that you deposit into their vaults for safekeeping, or otherwise lend out your money to other customers (in the form of loans or credit), they pass on a portion of the resulting revenue to you in the form of interest, which is usually expressed as an annual rate.
If you think about it, allowing you to earn from interest on a savings account also works out for your personal budgets, as without a tangible benefit from keeping your money stashed away, you might otherwise just be tempted to spend all that hard-earned cash right away.
(Com)pound it!
You should see regular interest payment transactions on your account statements, ever so slightly increasing your deposit balances. You can either spend that money or keep it on the account so that it continues to earn interest.
Your savings can really build momentum when you leave the interest in your account – you’ll earn interest on your original deposit as well as the interest added to your account through a mysterious (ed: not really) phenomenon called compound interest.
For an example of how powerful the snowballing effect of compound interest can be, at his death in 1790, Benjamin Franklin left roughly $4,500 each to the cities of Boston and Philadelphia to be invested at 5% annual interest. Fast forward 220 years, and Boston’s fund was worth about $5.5 million, while Philly held $2.5 million. Impressive, but not even close to the $21 million predicted by Franklin, due to unexpected fluctuations in the actual interest rate applied.
Save often, and let interest work for you
While not all of us can wait 200 years to reap the benefits of compound interest, we do have something that Benjamin Franklin did not—the ability to continuously deposit more money into your savings account principal balance.
We won’t bore you with complicated formulas (because our job at the Academy is to simplify investing fundamentals for you), but an additional monthly deposit of $100 into your savings account with an annual percentage yield of 2% can go a long way toward building a comfortable financial cushion for yourself down the line.
It is becoming increasingly common for savings accounts to compound interest on a daily, weekly, or monthly basis, so be sure to check these specifics (along with minimum maintaining balances, periodic fees, etc.) with your bank in order to be able to choose a savings account that suits your transaction and investment needs.
All this said, take note that savings accounts also yield much lower returns compared to other potentially higher-yield investments, such as stocks. If this approach isn’t the only one you’d like to take, you can also explore alternative ways to make your money work for you, like investing in the stock market.
If you want to learn more, Academy will always be here to guide you through your investment journey and help you gain confidence in making decisions that work for you.
