Interest is the money you receive for loaning out funds, and it’s also the money you pay when you borrow funds. In a nutshell, it’s the amount charged for the privilege of using someone’s money.
If your savings account earns interest, your bank or credit union is likely using the funds in it to make loans. In return, your bank pays you interest. The more you deposit and the higher the interest rate, the more your account earns. Credit unions have a similar process, but they call interest “dividends.”
The national average savings rate is 0.05% APY. But some institutions — particularly those with online savings accounts — offer much higher yields, often more than 10 times the national average.
What is an interest rate?
Interest is usually expressed as a percentage of the borrowed or deposited amount, and that percentage is known as the interest rate. For deposit accounts that earn interest, the rate over a one-year time period is often expressed as the annual percentage yield, or APY.
If you’re borrowing money, a higher rate means you’re paying more for the privilege of using money, making the loan more expensive than it would be with a lower rate. But when you’re being paid interest, a higher APY means more money in your account. When it comes to opening a savings account, it makes sense to shop around for a high-APY option. (Jump ahead to compare three savings accounts with strong yields.)
What’s the difference between interest and compound interest?
Once a bank pays your account interest, you can withdraw the funds or leave them deposited. If you leave them in the account, that money also starts earning interest, on top of your original deposit, allowing your overall balance to grow more. This is known as “compound interest.” Taking advantage of compound interest helps you build up money faster over time. It lets your cash work for you, which is especially important when rates are low.
If you put $6,500 in an account that pays a 0.55% rate, you’d calculate the interest earned by multiplying the balance and the rate: $6,500 multiplied by 0.55% is $36, so you’d earn $36 in interest. It may not seem like a lot over the course of a year, but it’s more than the roughly five bucks you’d earn at the national average rate of 0.05%. Also, that $36 will continue to earn interest if it’s left in the account.
If the account earns 0.55% APY over a three-year period, the balance after that time would be more than $6,600. For an even better scenario, add in a monthly savings plan. Say you start with a $6,500 balance and deposit $100 monthly over a three-year period. The balance would swell to more than $10,200 with the added interest.
Many online savings accounts offer strong interest rates and have automatic savings programs. See the chart below to compare three options.
To estimate your interest in other savings scenarios, use NerdWallet’s compound interest calculator. You can compute your potential balance with various starting amounts and interest rates. You can also see how making monthly deposits could affect your balance.
It’s worth noting that interest rates on savings accounts are typically variable and can change at any time. Banks also offer certificates of deposit, or CDs, which give you a set interest rate for a certain time period, say six months or five years. But you generally can’t withdraw money in that period, or else you’ll have to pay a penalty.
Interest is money paid for the benefit of using money. When you have a savings account that earns interest, your financial institution is paying you for the privilege of holding your funds. The smart move is to pick an account that gives you strong interest rates and the ability to grow your balance easily.