Hi Friendos,
Today’s discussion is about interest on saving accounts, and ties to the discussion two weeks ago about sinking funds. For some of you, this interest rate math may be easy peasy because you already understand it – great! For others, it will be helpful to walk through this step by step.
I described how I have four different sinking funds I use for different purposes: federal income taxes, local property taxes, traveling, and a current saving goal. Each of these four funds is an actual savings account – I happen to use Ally because its high-yield savings accounts have decent rates and I find the website and account features easy to use. I appreciate that my money will earn some interest until I need or want to spend it.
Does it matter that the interest is earned across four smaller accounts instead of one big account? No. Why not? Because the $ amount of interest I will earn across four small accounts will add up to be the same as the $ amount of interest I would earn on one big account.
Let’s say at a particular point in time I had $3,000 sitting in my four sinking funds, distributed like this:
- Federal income tax fund: $1,000
- Travel fund: $1,000
- Property tax fund: $800
- Current saving goal fund: $200
Let’s start by assuming I am earning interest of 4% on these savings accounts and I will have the same account balance in each account for a full year. Here is the interest I’d earn in each account:
- Federal income tax fund: $1,000 * 4% = $40
- Travel fund: $1,000 * 4% = $40
- Property tax fund: $800 * 4% = $32
- Current saving goal fund: $200 * 4% = $8
That adds up to $120. What if instead of holding this $3,000 across four savings accounts, I held it all in one account? In one year, I’d earn interest of $3,000 * 4% = $120. It’s the same! We can see that it doesn’t matter if the money is split up across different accounts, it is the total balance across the accounts and the interest rate that determine the $ amount of interest I’ll receive.
That is really the key thing to know here: the interest you earn does not depend on how many accounts your savings are spread over, so use whatever number of savings accounts helps you manage things in the way that is best for you.
Disclaimer: The interest calculations I laid out above are not precisely how banks determine interest earned on savings accounts.
- High-yield savings accounts don’t pay interest once per year – at Ally I receive interest on a monthly basis.
- My math used a “simple” interest rate that does not consider the impact of compounding (if you leave the interest earned sitting inside the savings account, you will earn interest on your interest). The interest rate a bank quotes for a savings account is required to be an “annual percentage yield” (aka “APY”) which is a rate that does consider compounding. Requiring banks to report interest rates in this way (as an “APY”) facilitates comparison shopping for consumers.
- Account balances may vary throughout the month, so banks will calculate interest based on daily account balances. That way, you get “credit” for the portion of the month with a high balance, even if you end the month with a lower balance.
- Banks also adjust for the different number of days in different months.
- Interest rates can vary over time.
To precisely replicate the amount of interest paid on a savings account, you need to consider all these factors. In my example above, these factors mean the $120 might be a slightly different amount, but whatever that other amount, it would be the same for one-big-account as for multiple-little-accounts.
Conclusion: use whatever number of savings accounts helps you manage things best.
-Stephanie
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