A bank account lets you store money without having to hide it under the rug. These accounts are also insured by the FDIC, which offers financial protection in case the bank shuts down. However, you could be missing out by leaving your money in a bank account that is yielding little to no interest.
Placing your extra cash into an interest bearing account can move you closer to your financial goals and offers a risk-free way to make money. This guide will explore the different types of accounts and how they work.
What Is an Interest Bearing Account?
An interest bearing account is a bank account that gives you interest for the money you keep in your account. Interest income gives customers an incentive to keep their money with the bank instead of investing it in stocks or spending it on discretionary items. Some interest bearing accounts pay interest every day, while others conduct monthly payouts.
How Does an Interest Bearing Account Work?
Banks want you to keep your money in your account. It allows them to give out more loans and make higher profits. Some bank accounts yield interest to encourage people to stay on board. Interest bearing accounts have daily or monthly compounding interest. Daily compound results in higher interest income.
Most interest bearing accounts have more requirements than traditional checking accounts. You may be limited to a certain number of withdrawals each month, and some interest bearing accounts have penalty fees if you make early withdrawals.
Types of Interest Bearing Accounts
Consumers can choose from several types of interest bearing accounts. These are some of the top choices.
Savings Accounts
A savings account allows you to earn interest on your cash. It’s a variable interest rate, which means the rate on your savings account can change based on fluctuations in the Federal Funds Rate. Most banks only let you make six withdrawals per month from a savings account before charging a small fee for additional withdrawals. Some banks also have tiered savings accounts, resulting in a better interest rate if you have a higher balance.
Money Market Accounts
These accounts are similar to savings accounts. Interest rates are variable, and you can make up to six withdrawals per month before incurring fees. However, these accounts have check-writing privileges. You can also receive a debit card for your money market account.
Certificates of Deposit (CDs)
CDs have fixed interest rates for a specified term that usually ranges from three months to 10 years. You can select the term and receive the appropriate interest. Consumers have the option to reinvest interest into the CD or send interest payments to another bank account.
Fixed interest rates are advantageous if the Federal Reserve decides to lower rates. This event would result in lower yields for interest bearing accounts with variable rates, such as high-yield savings accounts. However, you will incur a penalty fee if you withdraw funds from your CD before its maturity date. Some CDs have no penalty fees, which gives you the flexibility to withdraw at any time. However, you will receive less interest in the future if you withdraw any amount from your CD.
Interest Bearing Checking Accounts
These checking accounts have lower APYs than the other accounts mentioned. However, you can find interest bearing checking accounts with APYs of around 0.50%. Most checking accounts have low yields, so you will have to look around for the best rates. Online banks usually have higher APYs for their checking accounts.
How Interest Works in These Accounts
Wondering how banks determine the rate you’ll receive? Here are some of the details to know about how interest works in these types of accounts.
Simple vs. Compound Interest
Simple interest is based on a percentage of your bank account’s balance. If you have a 2% simple interest rate on a $1,000 balance, you will receive $20 in interest income for the year. Compound interest works differently. Most banks compound interest daily or monthly, and the extra interest you receive raises your total balance.
If the same account with a $1,000 balance had a 2% interest rate with monthly compounding, you would receive 0.17% interest each month. After the first month, $1,000 turns into $1,001.67. Then, your next 0.17% interest payment is based on your new $1,001.67 balance instead of the $1,000 balance. Compound interest allows your money to grow faster than a simple interest rate.
How Interest Rates Are Calculated
You can arrive at an interest rate by dividing your bank account’s balance by the interest payments that you receive. If you receive $100 in interest from a $4,000 balance, you have a 2.5% interest rate.
Factors Affecting Interest Rates
The Federal Funds Rate plays a key role in determining interest rates. However, banks will also analyze their competition. Brick-and-mortar banks keep rates similar to each other, while online banks tend to have higher APYs. Digital banks can have higher-yielding accounts since they have less overhead.
Benefits of Interest Bearing Accounts
An interest bearing account presents several advantages that can move you closer to your financial goals. These are some of the highlights.
Growth of Your Money Over Time
Your money can compound daily or monthly with most banks. Increasing your net worth will give you more choices in retirement. Interest can also cover various expenses if you have a balance that is large enough.
Low Risk Compared to Other Investments
You don’t have to worry about a major correction impacting your balance. Interest accumulates risk-free in a bank account. Avoiding fees will ensure that you end up with more money in the future than you have right now.
Liquidity and Access to Funds
You can access funds from an interest bearing account at any time. While some CDs require that you pay a penalty fee to access funds before the maturity date, most interest bearing accounts do not present that issue.
Drawbacks of Interest Bearing Accounts
While interest bearing accounts give you a low-risk way to grow your money, there are some drawbacks to consider before putting all of your cash into these accounts.
Lower Returns Compared to Other Investments
Stocks and real estate can outperform high-yield interest bearing accounts by wide margins. Tax treatment further expands this gap since interest is treated as ordinary income. Meanwhile, stocks and real estate present multiple opportunities to secure a lower tax rate and reduce your taxable income.
Inflation Risk
An interest bearing account may generate risk-free returns, but inflation will reduce your real return. For instance, if a high-yield savings account has a 3% yield, but inflation is growing by 4% per year, your purchasing power will decrease if you use that high-yield savings account. Your returns must exceed the rate of inflation to ensure that your purchasing power doesn’t decrease.
Potential Fees and Account Minimums
Some banks have minimum balance requirements to qualify for the highest possible interest rate. Furthermore, you might incur fees for some of your banking activity. It’s good to review each bank’s fees and how to avoid them before opening an account.
How to Choose the Right Interest Bearing Account
You can choose from several interest bearing accounts, but some are better than others. These strategies can help you assess bank accounts and determine which one is right for you.
Assessing Your Financial Goals
Assess your short-term and long-term financial goals before opening an account. A CD with an elevated fixed interest rate may make more sense for a 1-3 year goal than a variable-rate savings account.
Comparing Rates and Terms
Ultimately, you want an interest bearing account that has the best rates and terms. Comparing multiple options will help you gauge how much interest you can earn. Online banks usually have better rates and terms than brick-and-mortar banks.
Understanding Account Requirements and Restrictions
Some banks have significant account requirements and restrictions, making it a hassle to start. Other banks have $0 minimum deposits and no monthly fees.
Opening and Managing an Interest Bearing Account
Are you ready to open an interest bearing account? These are the key details that will help you get started.
What You Need to Open an Account
You may have to provide a minimum deposit to open an interest bearing account. It depends on the bank. However, you will definitely have to provide personal information like your ID, proof of address, Social Security number, and other information.
Tips for Managing Your Account
Opening an interest bearing account means you’ll have to stay on top of another account for your finances. These are some tips to make account management a breeze:
- Check your bank accounts multiple times per week
- Write down any minimum balance requirements, fees, and other relevant information so you can access it at any time
- Monitor CD maturity dates and plan out what you will do with the money next
- Assess how much money you want in your interest bearing account and how much to put toward other investments
- Keep most or all of your finances with the same bank so you can see all of your accounts from one dashboard
Monitoring Interest Earnings and Account Activity
Review your bank account activity regularly to ensure that everything is going smoothly. If a high-yield savings account has a lower variable rate, consider looking for another account.
Strategies for Maximizing Your Earnings
Interest bearing accounts let you earn extra money in your idle cash. These strategies will help you maximize how much interest you earn from your accounts.
Regular Deposits and Savings Techniques
Making regular deposits to your savings account each month will ensure that your interest grows over time. You can also use several strategies to save money, such as reviewing your credit card balance and canceling subscriptions. Saving more money allows you to put more cash into your interest bearing account.
Exploring High-Yield Savings Options
Don’t rush to open an account with the first bank you find. Some financial institutions offer higher rates than the average bank. Looking around can be the difference between 2% APY and 4% APY.
Using Automated Savings Tools
Many banks have automated savings tools that let you move funds from your checking account to a high-yield savings account. These automations don’t require you to make manual transfers between accounts and can result in faster interest accumulation.
Conclusion: Making the Most of Your Money with an Interest Bearing Account
An interest bearing account lets you maximize how much you earn from idle cash. Not everyone wants to put their cash into investments like stocks and real estate, but it doesn’t make sense to ignore free money from an interest bearing account. Comparing choices will help you find an account that offers the most flexibility, as well as competitive rates and terms.
