Here’s what savers need to know about interest

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If you are looking to save money, then you want to take advantage of interest to build your wealth.

The term interest refers to the money you earn by keeping it on deposit with a bank through a savings account, certificate of deposit or money market account. Even some checking accounts will offer you interest. Banks give you this perk as an incentive to keep your money with them. Then, they can use your deposit to fund loans. If you’re a borrower, interest is also what you pay to the lender.

If you’re unfamiliar with interest or how it works, this guide will help you better understand it and show you how you can use it to your advantage to save more money.

How does interest work?

When you borrow money, you pay the bank a fee called interest. Then, when you make payments to pay down the loan, some of that money will go to the principal (your loan balance), and some of the money will go to the bank in the form of interest. It is how banks make money when they lend.

However, when you save money at a bank, you can earn interest on your money for doing nothing. If you open a savings account, many banks will pay you interest just for keeping your money with them. The longer you keep your money on deposit, the more money you can gain.

Interest on savings accounts is variable, meaning it can change at any time. Currently, we’re in a low-rate environment. The best high-yield savings accounts pay around 0.70 percent APY.

How do I earn interest?

To earn interest, you will want to open a savings account, certificate of deposit, money market account or a high-yield checking account.

The interest rates range based on product and bank. Some banks offer higher interest rates if you deposit more money with them. Other financial institutions offer the same interest rate regardless of your balance.

Regardless, you will automatically earn interest and the bank will periodically payout the interest owed to you in your savings.

What’s the difference between simple interest and compound interest?

Simple interest works by tying what you earn in interest with the original balance in your savings account. For example, if you originally deposited $5,000 with a simple interest rate of 0.70 percent, you will earn $35 in interest in a year ($5,000 x 0.007).

Compound interest works a bit differently — it’s interest that you earn on interest. Using the example above, if you deposit $5,000 into a savings account earning 0.70 percent annually, you will receive $35 in interest in that first year. However, in year two, you would earn interest on $5,035, or $35.25 in interest payouts. Interest can also compound daily or monthly in addition to yearly.

It shows your money grows quicker with compound interest. It is why it’s vital to ask banks if they offer savings accounts with compound interest. Doing so will help you maximize your savings.

What’s the difference between interest and APY?

While annual percentage yield (APY) is related to interest, APY is more nuanced: Unlike interest rates, APY shows you what you will earn on your savings in one year, factoring in how often interest is compounded in the account. The frequency varies. Some banks calculate interest daily and pay on it monthly, for instance. In these cases, you will earn money every day you keep the savings account opened. But a bank may only compound interest annually. Read the bank’s fine print before opening an account to know if the product is right for you.

Since banks compound interest at different intervals, the APY is the best number for you to use when comparing rates.

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Written by
Sean Jackson
Contributing writer
Sean Jackson is a contributing writer at Bankrate. Sean writes about budgeting, saving money and more.