Interest rates are more meaningful once you understand how they translate into dollars in your pocket. Running the numbers can tell you how much of a financial gain you can expect when you put your money into any particular account.
How to calculate savings rate
Interest can be calculated in two ways: simple interest and compound interest. To calculate simple interest, use the formula a = r * t * p where a is the amount of total interest you will earn, r is the rate, t is the time period, and p is your principal (the account balance). Just remember that percentages are expressed as two (or more) digits past the decimal point (2% is .02, and 2.5% is .025) and when we're talking about an annual interest rate, the time period is one year.
For example, if you have $1,000 in an account that earns 1%, the formula is
a = 0.01 x 1 x 1,000
a = 10 (this is the number of dollars you'll earn)
Simple interest is easy to calculate and can give you a good idea of how much you'll earn. But with a savings account, you'll actually earn a little more. That's because savings accounts pay interest more than once a year. Instead of simple interest, you'll earn compound interest, and that's a better deal for you.
How to calculate compound interest
Interest rates on a savings account are calculated more frequently than just once a year. Each time it's calculated, the interest is added to your balance. The next time interest is calculated, you have a bigger principal balance to use in the equation.
Using the same example, let's say that interest is compounded monthly. That means that instead of earning 1% per year, you earn one-twelfth of one percent per month.
a = 0.083 x 1 x 1,000
At the end of one month, you will have $1,000.83.
Now it gets better. In the second month, you will earn the same 1/12% but you get to multiply it by the bigger balance:
a = 0.083 x 1 x 1,000.83
At this point you're already earning interest on your interest. Your balance at the end of month two is $1,001.67, which is one penny more than you would have earned with simple interest on the same amount.
If you leave this money in the bank for 10 years and the rate doesn't change, you will have $1,104.20. Conversely, if you put the money into an account that earns simple interest, the balance will only grow to $1,100 in the same amount of time.
The more money you put into your savings account, the more it matters whether the account pays simple or compound interest. Compounding interest will help you hit each savings goal faster. The vast majority of savings and money market accounts pay compound interest. Some certificates of deposit (CDs) earn simple interest.
