Why do banks pay interest?
And how does savings account interest work?
Earning a couple dollars helping your parents rake the lawn or take out the trash was always exciting as a kid—it didn’t matter that it wasn’t a lot of money, you were just excited to watch your piggy bank fill up.
Bank interest is like that. While it may not feel like much now, over time interest can be a nice cushion to your savings account and help you reach your future savings goals.
Why do banks pay interest to their customers?
If you’ve ever wondered why banks pay their customers interest on the money in their savings accounts, the answer may be simpler than you think. When you open a savings account, money market account, CD or other type of deposit account, you’re forming a partnership with your bank. The bank can lend your money to borrowers in the form of loans, mortgages or credit cards, and in return you’re paid interest.1
How does a savings account earn interest?
Depending on your account, your bank could use either simple or compound interest to figure out how much money you’ll earn in interest. It can be good to know which type of interest your account uses, because it may affect your annual percent yield (APY). That’s the annualized rate that shows how much money you can earn in interest on that account over a year's time.2
Simple interest
Simple interest is calculated using only your principal balance, or the original sum of money deposited into your account. This type of interest doesn’t account for any interest you've earned over time. Meaning, if you started with $1,000 in your account, the bank will always base your interest on $1,000.3
Compound interest
Compound interest calculates your APY using your principal balance plus any interest you earn.4 Depending on your account, interest could be compounded daily, monthly, quarterly or annually. Meaning, if you started with $1,000 in your account and earned $5 in interest, the next time your bank calculates interest, they’ll base it on $1,005.
Here’s an example of how simple interest and annually compound interest could work over 10 years at 1%.
| Simple Interest 3 | Compound Interest 5 | |
|---|---|---|
| Initial Deposit | $1,000 | $1,000 |
| 1 year | $1,010 | $1,010 |
| 2 years | $1,020 | $1,020.10 |
| 5 years | $1,050 | $1,051.01 |
| 10 years | $1,100 | $1,104.62 |
How often does a savings account earn interest?
It depends on your account. With most savings accounts and money market accounts, you'll earn interest every day, but interest is typically paid to the account monthly.4 However, CDs usually pay you at the end of the specific term, but there may be options to receive interest payments every month or twice a year.6 If you aren’t sure how interest works for your savings accounts, it may be time to call your bank.
Why do we have to pay interest when we borrow money?
Interest goes the other way when it comes to borrowing. Banks and other financial institutions typically charge interest any time they loan money. Meaning, you pay back what you borrowed and then some.1
But how can banks afford to pay interest on their customers’ savings account deposits if they’re loaning out money? Generally, savings account rates are lower than the interest rates banks charge when they loan money.1
Whether you’re saving or borrowing, interest is a big part of banking. And while you may not be saving up for your favorite action figure or candy bar (or whatever you bought with that lawn mowing money), it’s still exciting to see your money grow.
