How Interest Rates Work on Savings Accounts
One of the necessary monetary tools to begin your financial journey is to have a savings account. Through a savings account, you get the privilege to save your money, transfer and withdraw funds. At the same time, it gives the chance of earning interest on the fund that is deposited in the account. Different banks have come up with various savings account interest rates meant for various schemes. Before you opt for any savings account, you must know how the interest rates work.
How the interest rate is calculated
The new mandate as per RBI instructs the banks to calculate the interest rate every day based on the last closing amount. Based on the rules of the respective bank and type of savings bank account you have opted for, the accumulated interest rate will get credited to the account on a quarterly or half-yearly basis. To provide more benefits to the account holders, the custodian bank RBI has recently asked all the banks to credit the savings account interest rates every quarter.
Here goes a simple formula to easily describe how the monthly interest rate is calculated on a standard savings account.
Savings account monthly interest rate: Regular balance * Total number of days in a month * Interest rate / Total number of days in a year.
Let us assume that the regular balance to be 4 lakh and the savings account interest rate is 5% per annum. The calculation will go out as follows:
Monthly Interest Rate: 4 lakhs * 30 * (5/100) / 365 = Rs. 1643.84
The interest earned via savings account falls under the category of income from other sources. Although savings accounts are not subject to TDS as per the Indian Income Tax Act, it is taxed according to the marginal tax rate if or when exceeds the margin of Rs. 10,000.
Interest on Interest
In the simplest words, Rs. 4 lakh at 5% interest per annum would yield Rs. 1643.84. This is the simple interest paid on the principal amount only. A savings account with compound interest will generate interest on the last incurred interest along with the principal amount. This concept of interest helps to grow the savings quite swiftly.
In case of a savings bank account, this interest will be compounded quarterly or semi-annually based on the rules of the respective bank and guidelines given by the RBI. With the new provision, the interest rate gets quarterly credited to account holders.
As per the numbers of the previous calculation, a savings account with the feature of interest on interest, earns interest on the primary amount of Rs. 4 lakhs during the first period. However, in the next period interest accumulates on the primary amount as well as on the previously earned interest of Rs. 1643.84.
When a small snowball is pushed down the hill, it continuously collects snow on its way. Once it reaches the bottom of the snow hill, it emerges to be a giant snow boulder. The snowball effect is a visual metaphor that reveals the power of compounding. It is not a quick-rich scheme that will double or triple our funds in a short time. In the real world compounding the wealth takes more time, but this doesn’t make the formula less effective or less powerful.
Basically, the snowball keeps compounding on its way down the hill. With each rotation, the snowball continues to pack more and grow bigger in size. This metaphorical representation shows how a small saving on your part in bank accounts can generate sizable funds over time.
Begin early and save often
Now even when the interest rates hit rock bottom, the compounding effect of interest rates in savings accounts will help accumulate wealth over time. It is relatively easy to discover the interest rates offered by various banks by checking and comparing it online.
Some banks have special savings bank account schemes with lucrative interest rates for the account holders. Savings bank accounts empower you to start your financial journey even with the minimum amount.
When you are planning to deposit your hard-earned money in a savings account, you can stay assured that the money is secured. You can access the money during any financial emergencies without having to pay any penalty. The interest rates offered under savings accounts may be on the lower side, however, it is a safe and effortless way of wealth creation.