Why is interest paid? Banks are in the business of lending money and accepting deposits. They use the money to generate more money. When you deposit money into a bank account, the bank will lend it to borrowers. They charge the borrowers interest at a particular rate. And from that, they pay you interest for your deposit.
You can earn more interest by investing in high-yield savings accounts and certificates of deposit as they offer significantly higher rates of interest.
What is an interest rate?
The interest amounts you earn on your deposits and what you pay on the loan amounts you borrow are calculated on the amount or principal involved. The interest amount is calculated as a percentage of the principal. This percentage is called the interest rate.
The interest rate you get on your savings account deposit is known as Annualized Percentage Yield or APY. The higher your APY, the more interest income you will earn. This should be your main criterion when looking to open a savings account.
On the other hand, when you take a loan, you should look for the lowest interest rate. This means you will pay a smaller amount every month as interest for the amount you borrow.
Are there different types of interest?
Yes, there are. Interest primarily comes in two forms – simple interest and compound interest. Simple interest is the interest amount you earn on the amount you deposit in your account. Now if you leave that interest earned in your account without withdrawing it, the next interest you earn will be calculated on the principal amount plus the interest already earned. This amount earned on the existing interest is called compound interest.
Compound interest helps you earn money at a much faster rate than simple interest. That is why it makes sense to let your interest earned remain in your bank account for some time. Let us try and understand this with an example.
Let’s say you deposit $10,000 into a bank account that assures you an interest rate of 0.60% per annum. Every year, you will earn $60 by way of interest. That’s $5 per month. This is called simple interest. Now, if you leave this $60 in the bank, you will earn additional interest on it as well. That would be compound interest. To make this even better, try putting a bit of your savings into this account every month. This will really help your savings grow.
What account gives me a high yield?
Usually, a regular savings account offers you the lowest rate of interest. High-yield savings accounts give you a better rate but usually require you to maintain a higher deposit amount. Another option you can look into is a certificate of deposit (CD). CDs also give you much higher interest rates. But they do not allow you to withdraw your funds whenever you want.
That said, the interest rate should not be the only criterion for choosing a bank account. Look at the facilities each type of account offers:
- Savings accounts offer low-interest rates but allow you to withdraw your money and deposit more whenever you like.
- High-yield savings accounts offer higher rates of interest and you can also operate your account as you wish. But you have to maintain a higher minimum balance.
- CDs offer you high-interest rates, but you have to keep your funds locked in for a specified period. Withdrawing before the maturity date will attract a penalty fee.
Also, keep in mind that the rates on savings accounts tend to change from time to time based on the decisions taken by your bank.
Interest is a good way to earn money on your savings deposits. While choosing an account to deposit into, look for the highest interest rate along with other facilities being offered. While borrowing, choose the lowest interest rate considering all other factors remain favorable.