If your savings account pays you interest on your capital at a regular interval, the interest is typically simple interest. For example, if you have $100 in a savings account that pays interest once a year, at a rate of 10 percent, you receive $10 interest at the end of the year.
If you take that $10 out of the savings account at the end of the year, but leave the original $100 in the account, you will receive another $10 in interest at the end of the following year. However, if you leave your $10 interest in the savings account, you will receive interest on the capital and interest on the $10 interest at the end of the next year.
Compound Interest
A savings account may advertise an annual rate of interest, but it may pay that interest more often than once a year. You may have $100 in a savings account that advertises an annual interest rate of 10 percent, but pays that interest every three months. After the first three months, you will receive a quarter of the amount of interest that is due annually, in this case $2.50. This is added to the capital amount you have in your savings account. At the end of the next three months, you receive a quarter of the 10 percent interest due on your $102.50. This is known as compound interest, because the interest paid includes interest on the previous amount of interest that was added to your account. At the end of one year, your interest payments amount to more than the simple $10 annual interest, because interest is paid on the interest you received at each payment stage throughout the year.
Annual Percentage Yield
Savings accounts often specify an annual percentage yield (APY) that reflects the amount of interest your capital will earn in a year. For example, if your savings account calculates and pays interest every six months, you will receive two interest payments each year. If you have $100 in the account, and the annual interest rate is 10 percent, you will receive half of the annual interest after the first six months. This $5 is added to your savings, so that you now have $105 in the savings account. At the end of the next six months, interest is calculated, and you receive half of the annual 10 percent rate, payable on your $105 of savings. This amounts to $5.25, so at the end of one year you have $110.25 in your savings account. This means that although the account pays 10 percent interest annually, the APY is actually 10.25 percent, assuming that you leave all your interest payments in your savings account for the full year.
Fixed and Variable Rates
A savings account may offer a fixed rate. Typically, a fixed rate of interest protects you from interest rate fluctuations, but you have to commit to keeping your money in the account for a specific period of time. For example, a bank may offer a fixed rate of 10 percent to savers who agree to keep their money in the savings account for one year. If interest rates fall during that year, savers still get the 10 percent interest rate. Savers who may need immediate access to their money at all times can put their money into a savings account with a variable rate. Variable rate accounts usually offer instant access to savings, but the interest rate paid on these accounts may be recalculated at any time, and may rise or fall in line with market interest rates generally.