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Understanding Interest

Why interest matters

When you put money into a savings account, your bank or financial institution will reward you with a percentage of the money saved in return for keeping your money with them. This is called interest.

Interest helps to make your savings grow. The higher the interest rate that your savings attract, the faster those savings will grow. Look for accounts offering an interest rate that's higher than the rate of inflation, where available, which is the rate at which the price of goods and services increase. Otherwise, the real value of your savings may decrease. And remember that you may have to pay tax on the interest you earn.

Choosing the right savings option often requires a balancing act between the interest rate offered, and the terms and features it comes with. For example, savings accounts offering higher interest rates may require you to:

  • Keep your savings in place for a defined period

  • Give notice to access your savings

  • Invest a minimum (or maximum) sum each year or specified period

By contrast, a flexible savings account, offering instant access, is likely to offer a lower interest rate.

Where you choose to deposit your savings will depend on what you're saving for. If you're building an emergency savings fund, for example, you'll probably want immediate access to your money, and so an account offering instant access would be important. However, if you're saving towards a deposit for a house, an account offering higher interest, but which requires giving notice to access your savings, may be a better option.

Compound interest

Compound interest is interest earned on previously earned interest. The longer you save, the more the interest you earn compounds. Compound interest quickly mounts up, and can significantly increase your savings over time.

For example, let’s say you invest $10,000 into a 5-year compounding GIC paying 1.20% annually. After one year, you’ll earn $120 interest. By the end of the fifth year, however, you have $614.57 in interest. With compound interest, every time interest is earned on your GIC, it is added to your principal. In other words, you are now earning interest on top of interest, not just interest on the principal.

Year Principal Year interest Total interest
1 $10,000.00 $120.00 $120.00
2 $10,120.00 $121.44 $241.44
3 $10,241.44 $122.90 $364.34
4 $10,364.34 $124.37 $488.71
5 $10,488.71 $125.75 $614.57

For example, let’s say you invest $10,000 into a 5-year compounding GIC paying 1.20% annually. After one year, you’ll earn $120 interest. By the end of the fifth year, however, you have $614.57 in interest. With compound interest, every time interest is earned on your GIC, it is added to your principal. In other words, you are now earning interest on top of interest, not just interest on the principal.

Year 1 1
Principal $10,000.00 $10,000.00
Year interest $120.00 $120.00
Total interest $120.00 $120.00
Year 2 2
Principal $10,120.00 $10,120.00
Year interest $121.44 $121.44
Total interest $241.44 $241.44
Year 3 3
Principal $10,241.44 $10,241.44
Year interest $122.90 $122.90
Total interest $364.34 $364.34
Year 4 4
Principal $10,364.34 $10,364.34
Year interest $124.37 $124.37
Total interest $488.71 $488.71
Year 5 5
Principal $10,488.71 $10,488.71
Year interest $125.75 $125.75
Total interest $614.57 $614.57

The earlier you start saving, the more time you have to earn compound interest. It’s a good idea to make regular deposits, if you can, to keep your money growing. It’s also best to avoid taking money out of your savings account as that reduces the amount of interest you’re earning.

Financial wellbeing

Find out more about the difference between saving and investing to help you decide what’s best for you.

Learn more about the advantages of saving early for your retirement, what a government pension looks like and how employer contributions can increase your pension amount.

Instilling good saving habits can help you met the financial goals you have outlined for yourself and your future.