A savings account in a bank is a simple deposit account where you can keep some portion of your income and earn interest on it. It is popular among salaried individuals and is also often the first step towards investing for many new investors. Additionally, a savings account serves as a source of liquid funds as the depositor can withdraw their funds at any time. Let’s understand the process of earning interest from a savings account.

How is interest calculated?

The bank pays you interest when you put money in your savings account. It does so because your deposit is the money the bank is “borrowing” from you, and the interest paid is the “borrowing cost”.

Interest can be in two forms: simple and compound. In the case of simple interest, the principal amount remains constant, whereas, with compound interest, the interest of every compounding period is added to the principal. Typically, banks calculate your savings account interest earnings using the compound interest formula.

Let us now see how the two are different with an example. If you put in Rs 5 lakh in a bank for three years at 5 per cent interest annually, by the simple interest formula, the bank would have to pay you Rs 25,000 as interest every year. Here’s the calculation: 500000 × 5 per cent (or 0.05) × 1 (one year).

After three years, the total interest charges paid to you will be Rs 75,000.

Now let us observe the compound interest route explained below:

As seen in the calculation above, you would have earned Rs 25,000 at the end of the first year, meaning your deposit is then Rs 5.25 lakh. In the second year, the interest calculation is the same: 525000 × 0.05 (5%) × 1 = Rs 26,250. So your interest earning is Rs 26,250 in the second

year, taking your deposit amount to Rs 5,51,250.

Using the same calculation, you earn an interest of Rs 27,562.50 in the third year. Hence, the total interest you earn would be Rs 78,812.50 (Rs 25,000 + Rs 26,250 + Rs 27,562.50).

Comparatively, the interest earned by the simple interest method would be Rs 75,000. You earn more by the compound interest method.

You can utilise the compound interest system to create wealth and build a healthy nest egg for your retirement by reinvesting the interest earned over the long term.

Another interesting fact: if your investment is in a scheme where the interest is compounded monthly, you will earn more than if the compounding is quarterly. That is because, in compound interest, interest is calculated per period of compounding and added to the balance immediately. Over time, the balance gets bigger.

That’s where the annual percentage yield (APY) comes in. It is the real rate of return earned on a deposit or investment and considers the result of compounding interest.

Factors that affect interest earnings

It is important to note that the prevailing interest rates can change, as they are primarily driven by demand and supply (of credit or, in the case of a savings account, deposits). So the more the deposit in your savings account, the higher your balance, and the larger your interest earnings.

Account fees can also eat into your interest earnings for apparent reasons.

Two other factors are inflation and the government’s monetary policy. That means the estimated savings (yield) may not be as per calculations, i.e. if rates change because of government policies.

A famous example is Benjamin Franklin’s legacy of USD 4,500 each for Boston and Philadelphia. Franklin wanted the money invested for 100 years, three-quarters of it spent on something worthy after that period, and the balance reinvested for another 100 years.

He calculated that at 5 per cent interest, compounding would lead to a combined USD 21 million amount for the two cities, but as he had not bargained for falling/changing rates, the net amount in 1990 was USD 7 million.

Furthermore, deposit frequency also affects yield. For instance, an investment at an annual interest rate of 6 per cent will yield higher amounts for smaller compounding periods:

● Daily – 6.18 per cent

● Monthly – 6.17 per cent

● Quarterly – 6.14 per cent

● Half-yearly – 6.09 per cent

● Yearly – 6 per cent

How to maximise interest earnings

Before you open a bank account, find out which bank offers the best interest rates for savings accounts. Look for reasonable introductory rates, compare APYs, and look for tiered interest accounts, whereby the rates increase as your balance grows.

You should consider the various account fees that may reduce your savings. Banking at IDFC FIRST Bank can help you avoid unnecessary charges. It offers zero-fee banking on 28

commonly-used services on savings accounts.

A savings account provides safety and can also be an investment tool if you play it right. One way to do that is by maximising interest earnings, which is why you should compare rates and fees when opening a savings account.

With IDFC FIRST Bank, you get higher-than-average interest rates, monthly interest credits, exceptional debit card privileges, in addition to a superior customer experience. You get access to a host of banking services at zero fees. Open your IDFC FIRST Bank Savings Account today!