Breaking Into Saving: Understanding Savings Account Rates
You may have heard people talking about “the power of compound interest” before. It might sound a little grandiose, but it’s true. This term refers to the snowball effect that happens when you earn interest not only on the original money you invest, but on the interest you earn from this investment. As such, compound interest is a powerful tool for growing your wealth, and is an important factor to keep in mind when choosing a savings account. After all, when used intelligently, savings accounts are not simply a place to store your money, but a place to grow your money.
How Savings Account Rates Are Calculated
Assume you put $1,000 into a savings account that paid 1% interest per year and didn’t charge any fees. At the end of one year, assuming you didn’t take out or add any money to the account, you would be left with $1,010: $1,000 + (1% x $1,000).
However, this calculation actually determines simple interest, not compound interest. Because savings accounts pay interest more than once a year, the interest that gets added into your account also earns interest. So, presuming your account compounds interest daily—meaning that every day the amount in your account grows by another 1/365th of 1%—the savings account in the previous example would actually have $1,010.05 at the end of one year.
Now, let’s imagine that instead of leaving your original deposit in your account to grow on its own, you are regularly contributing more money your savings. Say you deposit a further $100 a month into this account. After one year, you would have earned $16.57 in interest.
So, how does this all look to you, the customer? Well, when financial institutions advertise their savings account rates, they will display them in the format of x.xx% Annual Percentage Yield (APY). Note that this figure already takes into account compounding effects. For example, going back to the example above, the final amount in the account was $1,010.05, which is a total return of 1.01% over a year. Hence, financial institutions advertise the savings account rate as 1.01% APY, as that is the interest your money will earn in a year.
Different Types of Savings Accounts
Savings accounts are largely differentiated according to four main factors: interest rates, minimum balances, withdrawal conditions, and fees. Interest rates refer to the APY, and typically the higher the APY offered, the higher the required minimum balances and the stricter the withdrawal conditions. Fees can include items such as monthly service and inactivity fees, ATM withdrawal fees, and account closure fees.
For example, at Citadel, we offer four different types of savings accounts. These are all federally insured up to $250,000 per member by the National Credit Union Administration.
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These accounts have the lowest interest rates but also the lowest minimum balances. They include free withdrawals from any Citadel ATM.
These accounts have much higher interest rates but also require a higher minimum balance to be maintained. Additionally, they include one free withdrawal per quarter, with subsequent withdrawals accompanied by a $25 fee to promote saving.
Money market accounts are like a blend between savings accounts and checking accounts. They offer higher interest rates compared to regular savings accounts, but have higher minimum balances. The difference is that unlike savings accounts, you can write checks from this account, giving you added flexibility.
Commonly referred to as fixed deposits or certificates of deposit (CDs) at other financial institutions, certificates offer the highest interest rates. In return, the funds in the account are locked in for a period of time. The longer the lock-in period, the higher the interest rate offered.
Which Savings Account Is Right For You?
When deciding which type of savings account is right for you, ask yourself whether you will be able to maintain the required minimum balances and how often you think you would need to access your savings. It is also worth considering what you are saving for, so use our Savings Calculator to get a clearer idea of what type of account would be best suited to your goals. You can also schedule your free financial planning consultation with us and we will personally work with you to help you get the most out of your savings!