A perk of having a savings account is the monthly interest credited to your account. While the interest payments by banks motivate the general public to save more, it also helps them plan their finances more effectively. Knowing how much interest amount will be credited to your bank account each month allows you to reconcile your closing balances with confidence. The fact that the bank genuinely pays you to deposit a sum of money is a strong incentive for choosing a savings account.
Generally, savings accounts receive interest payments based on compound interest. However, some banks might apply a simple interest method for certain account types or calculation periods. In this article, we will learn these interest calculation methods. So, read on to gain clarity on how to calculate interest on a savings account once and for all!
Defining Savings Account Interest
Interest refers to the amount you pay or receive on your principal amount. If you deposit a sum of money with a bank, you are entitled to receive interest. While seeking a loan, the bank or lender may charge interest from you.
Interest on a savings account falls under the former situation where you will receive interest for your money deposited with a bank or financial institution. This serves as a bank’s initiative to promote more savings and maintain its cash flow. However, before learning how to calculate interest on a savings account, it’s essential to understand the types of interest payments made by banks.
Types of Savings Account Interest
Savings account interest payments come in two forms – simple interest and compound interest. Most banks pay compound interest on the amount in the savings account. However, the underlying calculation for each interest period often uses a simple interest approach on the current principal before compounding. Both methods of calculating interest are stated below:
- Simple Interest: This is the interest earned on the principal balance of your savings account. Simply put, it is calculated solely on the initial principal or the total value of your deposits, not on accumulated interest. In this model, the interest earned each period remains constant, as it doesn’t accrue on previously earned interest.
- Compound Interest: This is the interest earned on both the initial principal amount and the accumulated interest from previous periods. Unlike simple interest, which is calculated only on the principal, compound interest accounts for the increasing balance over time.
Also Read: Savings Account Features You Should Be Aware of
How to Calculate Interest Earned on a Savings Account?
A clear understanding of the interest amount you are entitled to receive is simplified and more convenient with services like online interest calculators and comprehensive e-bank statements. However, if you still want to understand the manual calculation, then the following formulas may help.
Simple Interest = P x R x N
Here, P is the principal amount/ beginning balance
R is the rate of interest (generally converted in decimals)
N is the number of the time period for calculation
Let’s say you deposited INR 10,000 at the rate of 1.5% per annum in your bank. Your interest calculation for the year will be like this:
Applying the formula – P x R x N
10,000 x 0.015 x 1 = 150 (interest earned for the year)
The formula for compound interest for the same scenario is provided below.
Compound Interest = [P (1 + R)^N] – P
[10,000 (1+0.015)^1]- 10,000 = 150 (interest earned for the year)
Let’s calculate the compound interest for the next three years:
Year 1:
Compound Interest = [10,000 (1 + 0.015)^1] ― 10,000 = 150 rupees (INR)
Year 2:
Principal (P) = 10,000 + 150 (previous year’s interest)
Compound Interest = [10,150 (1 + 0.015)^1] ― 10,150 = 152.25 rupees (INR)
Year 3:
Principal (P) = 10,150 + 152.25 (previous year’s interest)
Compound Interest = [10,302.25 (1 + 0.015)^1] ― 10,302.25 = 154.53 rupees (INR)
Therefore, the compound interest earned for the next three years would be 150 rupees (INR) in the first year, followed by 152.25 rupees (INR) in the second year and 154.53 rupees (INR) in the third year. Financial institutions usually pay interest on your savings using the compound interest method.
Check Out: Compound Interest Calculator Online
Important Facts About Savings Account Interest
Now that you know the formula to calculate interest on a savings account, it’s important to stay informed about your interest earnings and relevant regulations. Here are some important points regarding savings account interest that you must keep in mind:
- Banks usually credit the accumulated interest on a quarterly or semi-annual basis.
- The compounding effect takes place every quarter, as the interest earned from the previous quarter is added to the account balance.
- Different types of savings accounts result in varying interest rates. With premium or high-yield savings accounts, the banks typically offer higher rates.
- Maintaining higher balances in your savings account often leads to an increase in the interest rate you earn.
Interest on a savings account may be calculated daily, monthly, quarterly, or annually, depending on your bank account type. The calculation of this interest often confuses many. This article has addressed the question of how to calculate interest on a savings account. With the methods mentioned above, one can easily calculate their interest earnings. Among these methods, financial institutions commonly use compound interest to maximize customer earnings over time.
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