How do savings accounts work?

A savings account is essentially a place you can park your money where it will accrue interest. In other words, if you have money in a savings account, a bank or financial institution will effectively pay you for storing your spare cash with them.

Unlike term deposits, a person can typically add money to or remove money from a savings account whenever they wish without consequence. And unlike term deposits, savings account interest is compounded, meaning your interest earns interest.

Though, some savings accounts limit how many times you can withdraw money in a given period. You might also sacrifice bonus interest if you withdraw money or neglect to grow your balance.

So, what’s in it for the bank? Well, a bank typically uses deposited money to help fund the loans it provides borrowers. Those borrowers generally pay a higher rate of interest than that offered to depositors, with the bank taking the difference – called a net interest margin (NIM).

It’s worth noting that the interest earned on a savings account is typically considered taxable income. It might be worth reaching out to an independent expert if you’re worried about the tax implications of opening a savings account.

What does interest mean in the context of a savings account?

If you’ve ever taken out a loan before, you’re likely across what an interest rate is. It’s the rate that a bank or lender charges you for borrowing money.

But what is interest on a savings account? The interest rate on a savings account is, in essence, the amount bank or financial institute will pay you to store your money in a savings account. Like those on loan products, interest rates on savings accounts generally fluctuate alongside the cash rate, set by the Reserve Bank of Australia (RBA).

But selecting a savings account isn’t always as simple as opening that with the highest interest rate and going on your merry way. Oftentimes, the highest interest rates available are offered as a ‘bonus’ and can only be realised by depositors willing to regularly jumping through set hoops.

What is base and bonus interest?

If you’ve browsed some of the highest interest rates offered among savings accounts on InfoChoice, you likely noticed a stark difference between an account’s ‘base’ interest rate and its ‘bonus’ or ‘max’ interest rate.

Bonus interest rate:

A bank or finance institute will often put stipulations on savers receiving their highest available interest rate. It might demand they deposit a certain amount each month, grow the balance of their savings account, or make a set number of purchases using an attached debit account.

Some banks and financial institutes also offer a higher ‘honeymoon’ interest rate to new customers for a period of time, after which the base rate is instated.

Base interest rate:

If a bank or institute doesn’t offer bonus interest, or if a person fails to qualify for bonus interest, they will likely receive a savings account’s base interest rate. If an account offers a bonus interest rate, its base interest rate is typically significantly smaller – sometimes more than 10 times lower. It’s not uncommon for a base interest rate to be just 0.10% p.a. meaning if you fail to meet the criteria you’re potentially missing out on a lot of money.

What is compound interest?

Compound interest is a complex topic with a very simple premise. It is the interest earned on interest. Let’s consider an example:

  • Cam Pound has $5,000 and his savings account option boasts a respectable 4.5% interest rate, calculated daily and paid monthly. He doesn’t plan on adding to this pot of savings and will keep all the interest he receives in the same savings account.
  • Cam receives $230 of interest in the first year of holding the account. A simple interest method - which is commonly found on term deposits - would yield $225 in the first year.
  • That means that he’ll start the second year earning 4.5% interest on $5,230 – boosting the interest he receives to $240 during the course of the year.
  • Then, he starts the the third year with $5,470 in his savings account and goes on to earn another $251 of interest over the year.

Continuing this pattern, the balance of Cam’s savings account will have doubled within 16 years, but he’ll have to pay tax on the interest earned every financial year.

The chart below provides another example of compound interest, this time considering how interest would compound and their savings balance would grow if a person was to deposit $500 every month:

Is your money safe in a savings account?

A savings account is one of the safest places a person can keep their money. Unlike other investment options, such as property, shares, or bonds, you won’t lose money kept in a savings account on the back of market movements.

However, there is always a chance that a financial institution could collapse, potentially taking some depositor’s savings with them. In such cases, the Australian Prudential Regulation Authority (APRA) guarantees up to $250,000 deposited by a person in a single licensed bank, building society, or credit union as part of the Financial Claims Scheme (FCS).