- Banks offer several types of interest bearing accounts including savings and money market accounts. Certificates of deposit (CDs) can also be considered interest bearing accounts. Although banks offer all these choices, they figure interest on bank accounts in the same basic way for each.
- All bank accounts that pay interest do so based on an annual percentage rate called simple interest. For example, if an account pays 4.8 percent annual interest, then at the end of the year $48 would be added to an account with a principal balance of $1,000. If you have a CD and the interest is paid to you once per quarter instead of being added to the balance, this is how much interest you would earn (each quarterly payment in the example would be 1/4 of $48, or $12). However, with most bank accounts interest is calculated and added periodically to the balance of the account. The added money then starts earning more interest, a process called compound interest.
- In compound interest, the annual interest rate is divided by the number of compounding intervals. For example, you would divide by 12 if interest is compounded monthly and by 365 if it's compounded daily. The balance in the account is multiplied by this periodic rate to find the interest earned for the period, which is then added to the account. This process is repeated for whatever length of time you wish. For example, if an account with a balance of $1,000 pays 4.8 percent interest annually and is compounded monthly, divide 0.048 (4.8 percent) by 12 to find the monthly periodic rate (here, 0.004 or 0.4 percent). Multiply 0.004 by $1,000 to find the interest earned for the month ($4) and add it to the account for a new balance of $1,004.00. To calculate more than one month's interest repeat as many times as needed, using the final balance for each month as your new balance for the next calculation.
- Needless to say, it's tedious to calculate periodic interest one step at a time as described above, especially since most accounts are compounded daily. In practice you want to use a formula that is a concise expression of the basic concept outlined above that you can enter into a calculator or computer program. The formula is P(1 + r)^n = B where P is the principal (starting balance), r is the periodic rate, n is the number of periods to be calculated and B is the final balance. Expressed this way, the above example looks like this: $1,000(1 + 0.004)^12 to find the balance at the end of 12 months. The answer is $1,049.07, so the account earns a little more when compound interest is used than the $48 you'd get with simple interest.
