Interest is a fantastic way to grow your savings, but interest rates, compounding and account conditions can all affect how much you earn. Before choosing a savings account, it’s helpful to understand how interest works. Our guide breaks down how interest is calculated and paid so you can choose the right account and make the most of your savings.

How interest works

When you deposit money into a savings account, the bank pays you interest as a reward for keeping your money with them. The interest rate is expressed as a percentage of your account balance, known as the annual percentage rate (APR).

The main things that affect how much interest you earn are:

• The interest rate
• How often interest is added to your account (compounding frequency)
• The amount of money in your account (your savings balance).

The interest rate

The interest rate determines how much you will earn on your savings. It is usually quoted as an annual rate, but the actual amount you receive will be based on how often the interest is calculated and paid. Higher interest rates mean you’ll earn more money on your savings over time, so it’s a good idea to compare rates when choosing a savings account.

How is interest calculated

Interest can be calculated and paid in several ways, but when it comes to savings accounts, the most common method is called compound interest.

What is compound interest?

Compound interest is when interest is calculated on your savings balance and any interest you’ve previously earned. This means you’re earning interest on your interest. It’s a great advantage for savings accounts because it helps your money grow faster over time.

The compounding frequency

Interest is calculated at set intervals, usually daily, monthly, quarterly or annually. In banking terms, we call this the compounding frequency. The more frequently interest is compounded, the more you earn over time.

Common compounding frequencies include:

• Daily: Interest is calculated and added to your daily savings balance. Daily compounding can lead to higher earnings compared to less frequent compounding because interest is calculated on a more regular basis. If you make a deposit, the interest will be calculated on the higher balance plus the previously earned interest the very next day.
• Monthly: Interest is added to your account balance at the end of each month. This means your interest earns interest on a monthly basis.
• Quarterly: Interest is compounded every three months, which is less frequent than daily or monthly compounding but still contributes to the growth of your savings.
• Annually: Interest is compounded once a year. While this is the least frequent compounding method, it still allows your savings to grow over time.

How interest is paid

Interest is paid to your savings account on a regular basis, usually each month. This means that every month, the bank deposits the interest you’ve earned into your savings account. In the next period, you’ll start earning interest on that new, higher balance.

Other considerations when choosing a savings account

Some savings accounts have conditions that can affect the interest you earn. It's important to choose an account that fits your saving habits. Here are a couple of things to watch for:

1. Minimum balance requirements
   Some accounts require a minimum balance to earn interest or avoid fees. You may lose interest or incur a fee if your balance drops below this amount. Remember to check the minimum balance requirements when opening a savings account.
2. Impact of withdrawals
   Making withdrawals can reduce the interest you earn. This is because many accounts calculate interest based on your daily balance. Also, some accounts limit the number of withdrawals you can make, charging a fee or paying a lower interest rate if you go over, which could affect your overall earnings.

Benefits of understanding interest

Knowing how interest works before you open a savings account will help you make an informed decision and maximise your savings. Your savings can grow even faster by choosing a savings account with a high interest rate, frequent compounding and account conditions that work for you.

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