How Does a Savings Account Interest Work?

How does a savings account interest work?  Sometimes thoughts run through my head that are mundane and probably not the least bit interesting to those already interested in personal finance, but I thought I would write about how a savings account interest works.  The magic of compound interest on savings is just fantastic and awe-inspiring to see, and I love how you can get paid monthly for an annual rate.

Here’s the low down on how does a savings account interest work.

Savings Account INterest

A savings account is an account where you can plunk your hard earned money and earn interest on the amount that you have deposited.  Just like you need to pay interest when you borrow money, you get paid interest from the bank when you deposit money.  This is typically presented as an “annual percentage yield” or APY.  With many banks, the annual percentage yield is calculated daily and paid monthly, typically at the end of the month.

Let’s say the APY or annual percentage yield is 2.5%.

Let’s say you have $10,000 to deposit, you know, for safe keeping for an emergency fund.

If you hold the $10,000 for one year and the annual interest rate paid on your deposit stays at 2.5% and you don’t add any more money, at the end of one year, you will have earned $250 for having your money there for safe keeping.

$10,000 x 0.025= $10,250

What it would probably look like is $20.83 deposited into your account as ‘interest’ on a monthly basis.

Compound Interest on the Savings Account Interest

Now, my favourite part.

If you compound the interest (which will automatically happen if you don’t touch the money or if the interest rate stays the same), the the bank will pay interest on the interest you earned.

Using my favourite compound interest calculator from Getsmarteraboutmoney.ca, here is how much you would earn on the $10,000 over 5 years with a rate of 2.5%:

That’s $1330.01! 

Just for not touching your $10,000 over 5 years.

Difference Between Savings and Chequing

Chequing accounts are usually (according to The Motley Fool) where your day to day transactions are.  When I was younger, I thought I had a savings and chequing account with my main bank (the one I had since I was like, 13) but then I realized it was really two chequing accounts, since the ‘savings’ account (even though it was labelled as a savings account) had such measly interest.

I have since created a number of savings accounts so that I can move the money out of my main bank and make it more inaccessible for daily use.  The harder it is for me to cash the money out the better it will be for my savings rate.

For my personal savings accounts, I have savings accounts with:

• EQ Bank– you can see my review of EQ Bank here
• Tangerine Savings Account– you can read up on my Tangerine Savings Account review.
• Manulife Bank– the lowest rate of the bunch, but I ordered 100 cheques from years ago so I want to just use them up, LOL.  Here are the current rates with Manulife Bank.
• Royal Bank– the rate is a bit laughable for a high interest savings account (0.25%), but it is an eSavings Account for my US dollars
• Canadian Tire High Interest Savings Account

With each of these, the interest you are paid is calculated on a daily basis and paid monthly, but with the annual percentage yield.

Related: Best Joint High Interest Savings Accounts in Canada

High INterest Savings Accounts in Canada

Now that you know how a savings account interest works (like magic, compound interest magic), here are some high interest savings accounts in Canada, and how their rates compare to each other.  Obviously you would want to opt for the savings account that provides the highest interest but at the same time, the most flexibility and perks.

Things to look out for in a good savings account are being able to access your cash easily (many high interest savings account are not ‘brick and mortar’ so most if not all transactions are done online or without access to someone in person), making sure you have things like mobile cheque deposit or free transfers out.

These rates are usually much higher than a savings account rate with a typical conventional bank because many high interest savings accounts don’t have ATMs or physical locations for you to get access your money, many of them are accessed online instead of in a brick and mortar location.

High INterest Savings or a GIC?

An alternative, which is similar to a savings account is a guaranteed income certificate (or a CD- certificate of despots in the US) where you have a specified term and you will receive the agreed interest after the term has been satisfied.  As mentioned in this previous post about where you should park your cash, a high interest savings account or a GIC, with a GIC you normally get a higher interest rate than with a savings account.  Many people don’t touch their savings accounts within 3 months term (I don’t think I’ve touched my savings account in the last three months) and you can still get a good GIC rate (compared to savings accounts) with a 3 months term.  If you redeem the GIC prior to the agreed date you would normally lose the interest rate or sometimes the bank doesn’t allow you to redeem before maturity.

Taxes and the Interest Earned on Savings

Now, the $250 you earned on that $10,000 that you just had sitting there for one year seems fine and dandy, until you realize that the income you earned on this is taxed at your marginal rate.

Let’s say your marginal rate is 25%.  That means that you will have to pay $75 of that $250 to the government.

So in actual fact, the $250 you earned is just $175.

via GIPHY

Meh.

Of course you can mitigate this by keeping savings or investments taxed at the higher rates in registered accounts such as an RRSP or TFSA so that you can avoid paying higher taxes.  However, many (including myself) don’t want to waste the TFSA room with low yield investments such as savings accounts– instead, I opt to invest my TFSA with a DIY investment portfolio.

Related: Tax Efficient Investing in Canada 

Do you believe in the miracle of compound interest on your savings accounts?

How many savings accounts do you have?