10 Calculating interest on savings accounts
Interest payments are computed on a per annum basis. This means that interest earnings are based on the length of time you keep money in your account. So, for example, in cash terms the interest for a 6-month period will be half that for a full year.
If you have an average balance of £1000 in your account and the interest rate is 3% per annum then you will receive an interest payment for the year of £1000 x 3/100 = £30. The balance on your account will rise to £1030.
If the balance stays at £1030 over the next year and the interest rate paid stays at 3% per annum then the interest paid will be £1030 x 3/100 = £30.90. This will mean that the balance on your account will rise to £1060.90.
The interest is higher for the second year because interest has been paid not only on the original balance of £1000 but also on the £30 interest earned in the first year. This process, which is very important to understand when saving or borrowing money, is known as ‘compounding’. Interest that is paid on interest previously paid is known as ‘compound interest’.
Some accounts pay interest monthly, some quarterly and some half-yearly. But by far the majority of accounts pay interest annually. You should check which rate applies to your account.
The interest paid to you will be based on the average balance of your account during the interest period. It is not paid on the basis of the money you have in your account at the date that the interest is computed. So if the amount of interest paid to you looks a little odd given the money you have in your account, this will almost certainly reflect the fact that the average balance is different – perhaps markedly different – from the balance of your account on the interest payment day.
The next video offers you a chance to try an example of how interest earnings build up (or ‘compound’) on a savings account.
This example looks at the way compounding helps build up the balance in your savings account. But remember the same process of compounding would apply if you borrow money and fail to make repayments when due. Interest charged on borrowed money is normally higher – often much higher – than interest earned on savings accounts. You can see how quickly debts can build up if people do not manage the money they borrow responsibly.