Banking Explained: How do savings accounts earn interest
Savings accounts are an excellent way to grow your money. While savings account interest rates aren’t as high as other investments, they’re definitely something worth considering! But if you have no experience saving in such an account, you may wonder how your money will earn interest.
Savings accounts earn interest through compounding. The interest is compounded monthly, quarterly, or yearly and you can interest on the interest you’ve earned up to that point. The more frequently the interest is compounded, the higher your savings will grow.
Banking can seem like a complicated subject, but it’s not. We are here to help you learn more about banking to equip you with the right tools to make smart decisions with your money. We cover everything from the different types of accounts banks have and how savings accounts work. Let’s get started! Shall we?
What Types of Accounts Do Banks Have?
When you hear the word “bank”, you might think of a brick and mortar building where people go to deposit their money. While some banks like that are still around (we call them traditional banks), most banking has moved online or is conducted on mobile devices with no human interaction at all!
Banks offer various types of accounts based on your needs for liquidity and the amount of interest you’re willing to accept. These include:
Current Account
A current account is the most familiar type of banking account. It is sometimes called a checking or demand deposit account. You can write checks with this kind of bank account, and they serve as your primary source for withdrawing cash from ATMs.
This account is mostly used by traders, freelancers, or people paid in cash since it holds more liquid deposits. Current accounts also allow for overdraft facilities, meaning you can withdraw more money than you have in the bank.
However, unlike savings accounts, you don’t earn interest on your money deposited in the account. Not to mention, you have to maintain a specified minimum balance in the account to take advantage of the services.
Savings Account
The main feature of a savings account is that it pays out interest on your deposits. This account is mostly used by people who don’t need their cash to be easily accessible and can take advantage of compound growth (interest-earning interest).
Savings accounts are also beneficial for those looking to establish an emergency fund, save for long-term goals or invest their money in diverse places without worrying about losing it all in one investment fails. However, unlike current deposit accounts, the number of transactions is usually limited, and the account comes with a higher minimum balance requirement.
Most banks offer various types of savings accounts based on:
- Type of depositor
- Age or purpose of holding the account
- Features of the product
Whether you’re opening the account as an individual or as a group
Salary Account
As the name suggests, a salary account is opened in the name of an employee paid through this account. With this account, the employer can deposit the employee’s salary, and the employee can withdraw money for regular expenses with ease.
The employee has the freedom to choose which type of account they want based on the features they’d prefer.
Fixed Deposit Account
If you’re looking to earn a decent interest rate on your money, a Fixed Deposit account is for you. Banks offer fixed deposits with different tenure options, typically between 7-90 days to more than five years.
The money cannot be accessed through withdrawals before the maturity period ends, and this makes these accounts stable in terms of returns on investment (ROI). However, some banks offer the option of premature withdrawals. However, in such a case, you’re interest rate may be significantly lower.
Recurring Deposit Account
Another popular savings account, a recurring deposit, offers higher interest rates than simple saving accounts.
However, the money cannot be withdrawn before maturity. If you withdraw early, your interest may drop significantly depending on how much time is left until the end of the tenure period.
The main difference between a recurring deposit account and a fixed deposit account is that you’re expected to deposit a fixed amount every month (and not once at the beginning), and you’re allowed partial withdrawals. However, in such a case, you’re interest rate may be significantly lower.
Source: HDFC Bank
What Is a Savings Account?
A savings account is like a piggy bank where you save money for the future and earn interest on it. The most basic feature of any savings account is that they offer fixed returns (on your deposited amount) at regular intervals, which could be monthly, quarterly or annual, depending on your tenure with this bank.
These accounts typically offer modest interest rates. However, their safety and liquidity (i.e. withdrawal) feature make them a preferred choice for most people, especially those who need quick access to their funds.
There are different types of savings accounts like:
- Traditional savings accounts
- Recurring deposit accounts
- Fixed deposit accounts
- Certificate of Deposit accounts
- Money Market Accounts
Source: Investopedia
How Savings Accounts Work
If you’re thinking of opening a savings account, chances are you might be wondering how the whole process works. It depends on the type of savings account you want. The most widely-used types are the traditional and recurring deposit accounts.
How Traditional Savings Accounts Work
Traditional savings accounts, sometimes called regular savings accounts, are simple accounts: they allow customers to save money over time by offering them an interest rate on their deposits. The interest rate is usually very low, but because it’s compounded monthly or yearly, the money in your account will grow faster.
In a traditional savings account, you deposit a fixed sum of money and earn interest on that amount until you withdraw from your savings account. You can make deposits as often as you want to this type of account without any limitation. If you decide to withdraw all your money, you’re allowed to do so because it’s compounded monthly or yearly, but you must leave a minimum amount in your account.
This is the type of savings account most people use as an emergency fund. It’s not high yield, but it makes sense to keep this money safe and accessible at all times without having any financial commitment with that part of your income.
How Recurring Deposit Accounts Work
Another popular savings account is the recurring deposit account. This type of savings accounts allows you to make fixed deposits into your account monthly for a specified period, making it an attractive option if you’re looking for ways to save money with small regular contributions.
The great thing about this type of savings accounts is that they offer higher rates of interest than regular savings accounts. However, they’re not as flexible as a current account.
When you open a recurring deposit account, it’s important to know that the money is locked in for a certain period and can only be withdrawn after that interval has passed without incurring any penalty. You’re also expected to keep up with your regular contributions, as you can’t stop them once they’re set up. Furthermore, you’re not allowed to withdraw the money before the agreed period is up.
Therefore, this savings account best suits individuals planning to stick with their monthly deposits for at least 12 months and don’t plan to touch the money until they’ve reached the agreed-upon date.
How Fixed Deposit Accounts Work
Fixed deposit accounts are a simple way to earn interest on your money. The account terms are flexible, but you must decide how long you want to save ahead of time and stick with that decision even if market conditions change or your financial needs change.
Fixed deposit accounts have no fees attached, so it’s easy to see what kind of earnings potential they have. Since the terms are set, you know exactly how much interest your account will earn when the saving period is up.
Account-holders can withdraw their money before maturity, but they’ll have to pay a penalty fee, usually a percentage of the amount withdrawn.
This account is best for those who know how much money they want to save for a set period and are willing to keep the funds in the account until maturity.
What Is Interest?
Interest is essentially an extra payment you receive for lending your money to another person or entity. When the financial institution where you have deposited your savings agrees to pay interest, it is essentially saying that they value your business and appreciate having the use of your funds.
Interest rates vary quite a bit depending on market conditions. Still, generally speaking, an account with higher interest will earn you more money over time, especially if you leave your funds deposited for several years
How Does Interest Work?
Interest is calculated based on how much money you have in the account. It can be paid out either monthly or yearly, depending on what terms are set by the financial institution offering the savings account. Some institutions will pay interest daily, which means more money for you at the end of the period.
How Do Savings Accounts Earn Interest?
Savings accounts make money by lending out the funds you deposit to other people, businesses and financial institutions at a higher interest rate which is their revenue. This also helps promote more liquidity in the marketplace as individuals contribute excess cash to savings accounts which can be used for investments or loans.
Therefore, think of a savings account as a business between you and the financial institution. They pay you a certain interest rate (or minimal amount) for your deposits while they can afford to lend out that money at a higher interest rate.
The more savings accounts are used, or how much cash an individual contributes above what’s needed on hand, the better it is for both parties.
Wrapping Up
There you have it! You now have a better understanding of how savings accounts work and the overall purpose behind them. Before you sign the dotted line and commit to any financial institution, make sure you’re working with one that offers competitive interest rates.
Also, remember to compare different accounts at various financial institutions. This way, you’ll get the best possible return on your savings. Most importantly, understand your saving goals and match them to the account that will best provide you with funds when needed. For instance, if your goal is to save over a long period, a fixed or recurring deposit savings account would be your best bet.
