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Bank Account Interest - Comparing Bank Account Interest - What is Bank Account Interest?

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When many people open a bank account they go in blindly because the bank was recommended by someone or they have a branch nearby. Instead of looking for convenience or just any old deposit account for savings or to make payments from, a financially savvy individual will look at a bank account for what it was meant to be in the first place – an investment.

When you look at a bank account from the perspective of an investor, the factors that become most important prioritize differently. At the top of the list, one factor reigns above all – bank account interest.

Comparing bank account interest should be of primary concern whenever opening a new account. Even if you don’t plan on opening a new account, your current bank account interest should be evaluated every year or two due to changing markets.

What is Bank Account Interest?

Bank account interest is money that is paid to you by the bank for allowing them to use it while it is in their hands. The bank uses your money for investment purposes and pays you an interest rate for the opportunity you give them.

Interest comes in two different forms: annual interest and compound interest. While the two sound very similar, there is a major difference between the two that can translate into a significant dollar value.

Annual interest is calculated by multiplying the annual interest rate against the principal balance at the end of a given term. The term can be more than one year or any portion of a year. The rate itself is multiplied by the term. This means an annual interest rate can be advertised but terms don’t necessarily have to be for a year. For example, a bank account with an annual interest rate of 2% with a term of six months is calculated by halving the interest rate because it is only for half a year, then multiplying it by the balance. If you deposit $5000 in this account, after six months it is multiplied by 1% (.01) for $50. At the end of the term, the bank gives you $5050.

By comparison, compound interest is paid periodically and automatically reinvested into the account as principal. The best bank accounts compound interest on a daily basis. To illustrate, say the above example, instead of having an annual interest rate, has a monthly compounded interest rate. At the same annual rate of 2%, this means that each month the principal amount is multiplied by .17% (2% divided by 12 months). With a $5000 deposit, you are paid $8.50 at the end of the first month. This gets added to the principal, so the second month is calculated by multiplying $5008.50 × .17% for an interest payment of $8.51 for the second month. The third month then begins with $5017.01, and at the end of the month it is multiplied by .17% for $8.53 in interest. At the end of the 6-month term, you will have made $50.21 in interest.

While the difference does not seem large in this example, when you compound interest on a daily basis for a long amount of time, say 10 years or more, in begins to add up quickly. If you took the same $5000 and kept reinvesting it and the interest made each year with an annual interest rate, after ten years you would have $6094.97. Take that same $5000 and put it in an account that compounds interest daily, after 10 years you would have $6106.98. The choice becomes clear that an account with compounded daily interest is in your best interests.

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