When you open a savings account, your bank will most likely give you an interest rate that will be paid on money you have deposited. But how exactly does this work? Is this rate the interest you'll get every month or every year? How often will interest show up in your account?
In this article, we'll go through the important details of how savings account interest works and what you should know about it.
Is your savings account interest rate monthly or yearly?
The short answer is that your savings account interest rate is expressed on an annual basis. However, the complete answer to the question of whether your savings interest rate is paid monthly or yearly is a little more complicated than it sounds.
There are three different interest rate concepts you should know in regard to your savings account:
Annual percentage yield (APY)
Annual percentage yield is the technical term for the "interest rate" your bank probably tells you or advertises for your savings account. And although the terms APY and interest rate are often used interchangeably, they actually mean slightly different things, which we'll get to in the next definition.
In simple terms, your APY is the yield you would get on your money after one year. As an example, let's say you deposit $1,000 into a savings account with a 4% APY. After one year, you can expect to have $1,040. Of course, this assumes you don't deposit or withdraw any money, and that your APY stays constant for the entire year, both of which aren't likely in real-world situations.
Because savings accounts typically express their interest as APY (with the "A" standing for "annual"), the short answer to our question is that your savings account interest rate is yearly.
It's also worth mentioning that savings account APYs vary significantly between financial institutions. Some of the best-known branch-based banks pay some of the lowest APYs on savings accounts, even in the rising-rate environment we're in. On the other hand, some of the top online banks pay much more. This is why it pays to shop around before you open a savings account, as you might be surprised by the difference in rates paid by different banks.
Compounding frequency
Here's where APY and interest rate differ. APY takes into account how often your interest is calculated by the bank. Interest rate does not.
As a simplified example, let's say your personal savings account has a 3% interest rate and your interest is compounded monthly. This means that instead of your bank calculating your interest once per year at 3%, it will calculate it once per month at one-twelfth of that rate, or 0.25% in this case.
The reason APY is different is a little mathematically complex, but here's the idea. If you have $1,000 in an account at 3% compounded monthly, after one month you'd have $1,002.50. When your second month's interest is calculated, it is based on that new higher amount, not the original $1,000.
Each month, the balance used to compute your interest gets higher. Your interest is then calculated on your original principal plus the interest that has accumulated so far. APY takes this effect into account. I'll spare you the math, but in this example, a 3% interest rate compounded monthly translates to a 3.04% APY. As mentioned, they are slightly different concepts.
The compounding frequency of savings account interest depends on your bank. Monthly or quarterly compounding are the most common, but other frequencies, such as daily compounding, aren't unheard of.
Payment frequency
Finally, payment frequency is how often the interest you've earned actually shows up in your savings account. And this isn't necessarily the same as compounding frequency. For example, it's entirely possible for a savings account to compound interest on a daily basis and pay interest monthly. Most savings accounts pay interest on a monthly basis, regardless of compounding frequency, although there are exceptions.
How savings account interest is calculated
We'll look at an example of how savings account interest is calculated, but here's the mathematical formula:
