WHAT IS THE DEPOSIT INTEREST RATE? (WITH EXAMPLE) - ECONOMY - 2025

The passive interest rate is the rate that a bank or financial institution pays to its savers for keeping the money in a bank account that pays interest.

The interest rate is the percentage of the capital charged by the lender, in this case the depositor of the money in the bank, for the use of their money. Principal amount is the amount of money you lend.

Source: pxhere.com

As a result, banks pay a passive interest rate on deposits made by depositors. They borrow that money from the depositor.

Anyone can loan money and charge interest, but it is usually the banks. They use savings account deposits or certificates of deposit to finance loans. They pay passive interest rates to encourage people to make deposits.

Banks charge borrowers a borrowing rate slightly higher than the deposit interest rate they pay depositors, in order to make a profit.

What is the passive interest rate?

The passive interest rate earned on savings accounts or other investment mechanisms is compensation to the account holder for allowing the bank to use the deposited funds.

For example, if a business deposits $ 500,000 in a high-yield savings account with a bank, the bank could take $ 300,000 of these funds to lend to a mortgagor at an annual lending rate of 15%.

To offset this loan business, the bank pays the depositor an annual deposit rate of 6% on his savings account.

Thus, while the bank takes 15% interest from the borrower, it gives 6% interest to the account holder. That is, the bank's lender makes a 9% profit on the interest rate differential.

In effect, savers lend money to the bank, which, in turn, lends that money to borrowers to earn interest.

Banks compete with each other, both for depositors to obtain money and for borrowers to lend it. This competition keeps banks' interest rates in a narrow range with each other.

Considerations for saving

Annual interest rate

The annual interest rate, sometimes called the base rate, is the percentage value that is usually seen first when comparing financial products. It is the basic interest that will be earned on the savings account regardless of composition or fees.

This means that the actual amount of interest earned will likely be higher than the stated annual interest rate.

The annual interest rate is the figure on which all other rates that need to be known are based. It's the base rate, and while it's not always the best way to compare different products at financial institutes, it makes up a large part of what to consider.

Effective annual interest rate

It is also known as a percentage of annual return. This is the percentage value that takes into account the effect of compound interest over the life of the account.

This is the number to look for to get a better idea of ​​how much interest the account will have each month.

Other considerations

The deposit rate is not the only important thing to consider when comparing banking products. Interest rates do not factor in additional fees, which could make a big difference.

The offer should be viewed as a complete package. That includes factors like rates, features, and special bonus offers.

Among the features to consider are the options for access to branches or online banking. Also introductory or bonus interest rate periods.

Interest rate types

Simple deposit interest rate

The annual simple deposit interest rate is calculated based on the following formula, which is:

Simple interest = Principal amount x Deposit interest rate x Time.

If, for example, an individual makes a bank deposit for $ 100,000, with a passive interest rate of 10% per year, he will receive $ 10,000 in interest at the end of the year.

If the term of the certificate of deposit is 20 years, the interest you will receive on your account will be equal to: $ 100,000 x 10% x 20 = $ 200,000.

The 10% interest rate translates to an annual interest payment of $ 10,000. After 20 years, the depositor would receive $ 10,000 x 20 years = $ 200,000 in interest payments.

Compound deposit interest rate

Also called interest on interest, it is a passive interest rate that is not only applied on the principal amount, but also on the interest accumulated from previous periods.

When an entity saves money using a savings account, it is favorable to have compound interest.

The bank assumes that at the end of the first year, it owes the depositor the principal amount plus interest for that year. At the end of the second year, the depositor receives the principal amount plus interest for the first year, plus interest on interest for the first year.

The interest that the depositor receives when capitalization is taken into account is higher than that of the simple interest method. This is because it charges the monthly interest on the principal, including the interest accrued from the previous months.

The formula for the compound deposit interest rate is: (1 + i / n) ^ (n - 1) where:

i = declared annual borrowing rate.

n = number of compound interest periods in a year.

Example

In the strictest sense, $ 1,000 at 1% interest per year would yield $ 1,010 at the end of one year. This is obtained with a simple deposit interest rate.

In the case of a savings account, the interest is compounded, either daily or monthly, earning interest on the interest.

The more often interest is added to the balance, the faster the savings will grow. With a daily compounding, the amount that will earn interest grows every day by another 1 / 365th of 1%. Therefore, at the end of the year the deposit grows to $ 1,010.05.

Now you can consider what would happen if you could save $ 100 a month and add it to your original deposit of $ 1,000.

After one year, you would have earned $ 16.57 in interest, for a balance of $ 2,216.57. After 10 years, adding just $ 100 per month, you would have earned $ 730.93 in interest, for a total of $ 13,730.93.

It is a reasonable fund for emergencies. That is the main purpose of a savings account.

References

1. Kimberly Amadeo (2018). Interest Rates and How They Work. The Balance. Taken from: thebalance.com.
2. Carol M. Kopp (2018). How Interest Rates Work on Savings Accounts. Investopedia. Taken from: investopedia.com.
3. Waiter (2019). Annual interest rate. Taken from: mozo.com.au.
4. Investing Answers (2019). Interest Rate. Taken from: investinganswers.com.
5. Investing Answers (2019). Effective Annual Interest Rate. Taken from: investinganswers.com.