You earn interest when you lend money or deposit funds into an interest-bearing bank account such as a savings account or a certificate of deposit (CD). Banks do the lending for you: They use your money to offer loans to other customers and make other investments, and they pass a portion of that revenue to you in the form of interest.4
Periodically, (every month or quarter, for example) the bank pays interest on your savings. You’ll see a transaction for the interest payment, and you’ll notice that your account balance increases. You can either spend that money or keep it in the account so it continues to earn interest. Your savings can really build momentum when you leave the interest in your account – you’ll earn interest on your original deposit as well as the interest added to your account.
Earning interest on top of the interest you earned previously is known as compound interest.
Example: You deposit $1,000 in a savings account that pays a five percent interest rate. With simple interest, you’d earn $50 over one year. To calculate:
- Multiply $1,000 in savings by five percent interest.
- $1,000 x .05 = $50 in earnings (see how to convert percentages and decimals).
- Account balance after one year = $1,050.
However, most banks calculate your interest earnings every day – not just after one year. This works out in your favor because you take advantage of compounding. Assuming your bank compounds interest daily:
- Your account balance would be $1,051.16 after one year.
- Your annual percentage yield (APY) would be 5.12 percent.
- You would earn $51.16 in interest over the year.
The difference might seem small, but we’re only talking about your first $1,000 (which is an impressive start, but it will take even more savings to reach most financial goals).
With every $1,000, you’ll earn a bit more. As time passes, and as you deposit more, the process will continue to snowball into bigger and bigger earnings. If you leave the account alone, you’ll earn $53.78 in the following year (compared to $51.16 the first year).
See a Google Sheets spreadsheet with this example. Make a copy of the spreadsheet and make changes to learn more about compound interest.