Calculating Interest on a Checking Account
January 19, 2009
How do you calculate interest on a checking account, anyways? The answer is surprisingly unknown. Many people don't even bother, thinking it's not much, so don't worry about it. Whatever comes in the mail at tax time, that's the interest that was paid. But this issue is worth taking a look at, so let's do just that.
Simple Interest vs. Compounding Interest
Simple interest is simple to calculate. You have $100 in a checking account that pays three percent interest annually. At the end of the year (assuming your balance stayed steady), you will have $103 dollars. Your original balance plus three dollars interest paid by the bank.
And then you have compounding interest, or "interest on interest." In this case, interest is calculated periodically, revising the balance upwards, and then interest is paid on the new balance. The calculation depends on when the interest is "credited" to the account.
If your eyes glaze over when algebra comes into the picture, there are a variety of tools available for making this calculation. But the bottom line is important to internalize, no matter what the actual figures are: compounding interest adds up quicker than simple interest, whether you're paying it (mortgage) or it's being paid to you (checking or savings account).
Checking Account Interest
It depends on the bank and the account terms, but checking account interest is usually compounding interest calculated daily, credited at the end of the billing cycle. Meaning that the bank pays the interest at the end of the month, but calculates the interest on a daily basis.
Interest rates paid vary according to customer and balance. One to two percent is pretty standard, but if you carry a higher balance, you may receive a significantly higher rate. Banks are eager to sign up customers for checking accounts, and therefore offer some good deals.
Ideally, you want the highest interest rate, compounded the most frequently, and credited the most quickly. That's the equation for maximum growth of the account.
Not That Big a Deal?
Some people will claim that if you're even thinking about how to calculate interest on a checking account, you're using a hammer for a job that needs a chisel, so to speak. And there is some logic to this argument. Other financial products, such as savings or money market accounts, pay higher interest than checking accounts, which are meant more for paying short-term expenses.
But this is not always true. There are "high yield checking accounts" that pay interest equal to or even better than the typical savings or money market account. However, some restrictions may apply with these accounts. For example, you may not be able to walk into a bank with any problems because the bank is exclusively on the Internet. But you receive higher interest on these checking accounts.
