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How Do Savings Accounts Accumulate Interest?

A savings account is the most common type of bank account and usually the first account a person opens. Such an account normally requires a small amount to open and maintain compared to other accounts such as a checking account. Some banks, however, require no minimum balance to be maintained at all. Opening a savings account allows an individual to keep his money in a secure place while at the same time allowing it to earn a small amount through monthly interest. Although interest rates on savings accounts may vary, a minimum rate is set for interest on savings accounts.

Money placed in savings accounts provide account holders the peace of mind that their money is safe and secure. In addition to the fact that you will not be able to spend it irresponsibly if the money is kept at home, it will not go into ashes once your house burns. Likewise, even if your bank gets robbed or burns down (though this is unlikely as most banks keep the deposits locked in a fireproof safe), you will not lose your saved money because it is insured.

The Federal Deposit Insurance Corporation, simply known as FDIC, provides insurance to savings accounts up to $100,000. The FDIC is an independent federal agency that was specifically created in 1933 as a result of the failures of thousands of banks to honor their commitments in the 1920s and early 1930s. Lots of people lost significant amounts of money because of that. However, since the FDIC was instituted, no one ever lost his entire savings in a bank again.

Money placed in a bank savings account earns monthly through a predetermined interest rate. Banks use deposits entrusted to them to fund loans they extend to borrowers. The earnings from these loans are used to pay off bank obligations including interest on savings accounts. However, you can get your entire savings in the bank anytime you need to as banks have provisions for such purposes. To explain it in layman's terms, here is how savings accounts accumulate interest:

  • A depositor opens a savings account at a particular bank.
  • The bank pays the depositor interest based on the amount of money left in the account. Usually, interest is computed daily and compounded monthly (compounded interest).
  • The bank uses the deposits to loan out to other people. They charge a higher rate of interest on such loans than what they pay as interest to their depositors. This is one of the ways for a bank to earn income from its operations and help keep it in business.

The compounded interest on savings accounts enables a depositor to earn money even on the interest that has already been earned. Interest is computed daily based on your daily balance. The total interest earned for the month is then added to your account balance. This is called interest compounding. The next month, assuming you made no withdrawals, daily interest is computed based on your daily balance including the interest paid for the previous month.

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