Help me to Understand How Interest is Earned on a Savings Account/Money Market Account.?

Question

This is how my bank says interest is accrued. "The interest is compounded daily and credited monthly." What does this mean? If I have 8000 dollars in the bank all month how would 5% interest accrue on that money?

Answer 1

The first answer is just wrong, he is referring to simple interest which is almost never used and it is certainly not used in your example as the bank specifically says that it is compounded daily.

There are different accrual methods 30/360, 30/365, Act/360, and Act/Act are the most common ones. We will assume that it accrues Act / 365. Using this assumption, it accrues like this:

Day 1: $8000 * .05 * 1/ 365 =
$8000 * .000137 = $1.10

So for the first 30 days your account will show a balance of $8000 and you will accrue $1.10 per interest each day. After 30 days a payment of ($1.10 * 30) or $33 will be made to your account. Assuming the interest rate doesn't change, the daily interest for month 2 accrues as follows:

$8033 * .05 * 1/365 = $1.10

After 30 more days the accrued interest is added to your balance in the form of a payment and it continues.

Answer 2

Think of it this way. 5% interest for a year on 8000 is 400 dollars.

They will build up to the 400 by giving you some each day.

If it were simple interest they would give you about 1.10 per day (400 divided by 365)

Compound interest works a little different. Since the first day they give you interest, you start earning interest on that amount, it is not as simple as just diving 400 by 365 days.

The formula is a little complicated so I won't go into it.

The key is that you end up with 400 at the end of the year and you get there a little at a time.