When was the last time you checked the interest rate on your savings account? If it has been a few years, you may want to check again.

Financial institutions will literally pay you to keep your money with them. While the average interest rate on a savings account is relatively low, you may find a better one if you shop around. With an excellent yield and frequent compounding, you can watch your savings grow exponentially.

So, how does interest work on a savings account? We’ll walk you through the basics of savings account interest, the factors that affect your rate and how to maximize your returns.

Basics of interest on a savings account

When you open a savings account, your bank or credit union will likely pay you a percentage of your balance called “interest.” Financial institutions do this to incentivize savers to keep their money with them. They then use the funds to create loans for borrowers, which is one of the primary ways financial institutions make a profit.

Interest is usually expressed as a percentage. Annual percentage yield (APY) factors in compounding. Savings accounts typically have compound interest — but more on that later.

The rates on savings accounts are usually variable, meaning the bank can change them whenever it wants. One exception, however, is certificates of deposit (CDs), which often have fixed interest rates.

Simple vs. compound interest: What’s the difference?

As mentioned above, financial institutions generally compound the interest on savings accounts. Compounding means you earn a percentage from your original balance (otherwise known as the principal) along with any interest you’ve previously received and left in your account.

The more often a financial institution compounds interest, the higher yields you will receive. Accounts typically compound either daily, monthly, quarterly, biannually or yearly.

Simple interest, on the other hand, does not factor in compounding. You only earn a set amount based on your initial deposit.

Compounding interest can grow your wealth exponentially. Simple interest will move your savings balance linearly and slower.

How to calculate interest in a savings account

If you want to know how much interest you’ll earn from your savings accounts, you can use the following formulas to calculate the simple and compound interest:

P x R x T = Simple interest

P (1+RN)NT = Ending balance with compound interest

P = Principal (starting balance)

R = Interest rate expressed as a decimal (for example, 5.25% would be 0.0525)

T = Timeframe (usually number of years)

N = Number of times interest compounds in the specified timeframe

Here’s a comparison of your balance with simple interest vs. compound interest over five years with an initial deposit of $10,000 and an APY of 5.00%:

As you can see, after five years, your balance would be $340 higher with compound interest than with simple interest.

Ways to maximize your savings account interest

Now that you understand how interest works on a savings account, let’s look at how you can optimize it.

According to Joseph Eck, CFP and owner of Stage Ready Financial Planning, you shouldn’t assume you’re earning interest on your savings with your current bank, even if you’ve been a loyal customer.

“Do your homework to learn what interest rate you are currently receiving and ask your bank if they offer accounts such as a high-yield savings account that is FDIC insured,” Eck said. “Also, consider exploring online banks as they tend to offer the highest savings rates today.”

Shopping around and comparing different financial institutions is key to finding the best rates. You may find better APYs at a credit union vs. a bank since they often pass their profits to members through higher rates. However, as Eck mentioned, online-only banks typically offer the best APYs. Without physical locations to operate, they have fewer expenses and can pass the savings to customers.

Here are some other tips to help you get the most out of your savings account interest:

Watch out for fees: When comparing savings accounts, check for balance requirements and monthly maintenance fees. You should also look out for other potential charges, such as ATM withdrawal fees, overdraft fees and inactivity fees. These fees can quickly eat up anything you earn in interest, so try to avoid them if possible.

Find bank bonuses: Some financial institutions will pay you a savings account bonus for banking with them. A bonus can help boost your balance so you can earn even more interest. However, there may be additional requirements, such as setting up direct deposits, making a minimum initial deposit or maintaining a certain balance.

Keep contributing: Setting aside a portion of your monthly income can expedite the growth of your wealth. Adding more funds to your balance means you’ll earn more interest, compounding into even higher returns. If you set up automatic transfers, you can save without thinking and remove the temptation of spending your whole paycheck.

Leave interest invested: If you withdraw your earnings from your savings, you will only earn simple interest and miss out on compounding. While this may make sense for those on a fixed income, such as retirees, you’ll see greater returns over time if you leave the interest in the account.

Explore other savings options: You can also look beyond traditional savings accounts to earn a better APY. CDs or money market accounts often offer higher interest rates than regular savings accounts. However, there may be minimum balance requirements and liquidity limits.

Factors influencing the interest rate of your savings account

With variable interest rates, the APY on your savings account can change at any time. But what factors affect it?

Federal funds rate: Many financial institutions set their savings account rates based on the benchmark interest rate set by the Federal Reserve. This is a target range for overnight lending between banks. If the Fed raises or drops the federal funds rate, financial institutions tend to follow.

Business model: A financial institution’s business model can also affect your interest rate. Credit unions and online banks may offer better APYs than traditional banks because they have different business structures and goals. How the financial institution reinvests the funds in your deposit account may also influence your rate.

Supply and demand: Financial institutions often compete with each other for deposits so they can create more loans. If a lot of people want to take out loans, a bank may raise the rates on its savings accounts to attract depositors so they can meet borrowers’ demands. However, if the supply of deposits increases, the institution may lower its APYs if it no longer needs the additional funds.

Economic strength: When the economy is weak, borrowers’ income is often less stable due to higher unemployment rates. Financial institutions may be reluctant to lend people money if they think there’s a chance they won’t pay it back. When banks issue fewer loans, they don’t need as many deposits and typically lower their savings account rates.

Frequently asked questions (FAQs)

Compound interest is when you earn a percentage from your principal amount as well as previously accrued interest. It can help you grow your savings balance faster than you would earning simple interest.

Yes, savings accounts typically have variable interest rates, so the amount of interest you earn could change at any time.

The interest rate on a savings account can be affected by the federal funds rate, supply and demand, the bank’s business model and the economy’s overall health.

This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.

Note: While the offers mentioned above are accurate at the time of publication, they're subject to change at any time and may have changed or may no longer be available.

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How does interest work on a savings account?