How to Make Interest on Money From Banks & Government

Earning interest on your money is a fundamental strategy for growing wealth, allowing your savings to generate additional money. Interest is the cost of borrowing money, where a borrower pays a lender a percentage of the amount borrowed. When you deposit funds into a bank account or purchase certain government securities, you act as a lender. Understanding how interest accrues and the various vehicles available is a foundational step in personal financial management, enabling a more informed approach to saving and investing.

Fundamentals of Earning Interest

Key terms for understanding interest include “principal,” the initial amount deposited or invested. The “interest rate” is the percentage paid to a depositor for the use of their money. The “interest period” specifies how frequently interest is calculated and applied, such as daily, monthly, quarterly, or annually.

Interest can be calculated in two primary ways: simple interest and compound interest. Simple interest is calculated only on the original principal amount. For example, $100 at a 5% simple interest rate annually earns $5 each year. This method typically applies to short-term financial products.

Compound interest is calculated on the initial principal and all accumulated interest from previous periods. This means earnings grow at an accelerated rate because the interest itself begins to earn interest. For instance, $1,000 at a 6% annual return compounded annually earns $60 in the first year ($1,060 total). In the second year, the 6% return is calculated on the $1,060 balance, yielding $63.60. More frequent compounding increases growth.

Understanding the difference between Annual Percentage Rate (APR) and Annual Percentage Yield (APY) is helpful. APR represents the yearly rate charged for borrowing money, including fees, but does not account for compounding. APY reflects the total interest earned on savings over a year, taking compounding into account. For savings accounts, a higher APY indicates a greater return.

Several factors influence interest rates. The Federal Reserve’s monetary policy significantly impacts rates; lower rates can stimulate economic activity, while higher rates aim to curb inflation. Inflation also affects interest rates, as lenders may demand higher returns to compensate for eroding purchasing power. Supply and demand for credit further contribute to rate fluctuations.

Earning Interest Through Bank Deposits

Financial institutions offer several avenues for individuals to earn interest on deposited funds. These products provide varying levels of liquidity and interest rates, catering to different financial objectives. Understanding each can help in selecting the most suitable option.

High-Yield Savings Accounts (HYSAs)

High-yield savings accounts (HYSAs) offer significantly higher interest rates than traditional savings accounts. They are often found at online banks, which can pass on higher rates due to lower overhead costs. HYSAs provide competitive annual percentage yields (APYs), often much higher than the national average for standard savings accounts.

HYSAs maintain high liquidity, meaning funds are readily accessible for withdrawals or transfers. However, these accounts may have limits on monthly transactions before fees. Deposits at banks are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per institution, per ownership category. For credit unions, similar coverage is provided by the National Credit Union Administration (NCUA). This federal insurance protects your principal and accrued interest.

Certificates of Deposit (CDs)

Certificates of Deposit (CDs) are time deposit accounts offering a fixed interest rate for a predetermined term, ranging from a few months (e.g., 3 or 6 months) to several years (e.g., 1, 2, 3, or 5 years). The interest rate is fixed for the entire term, providing a predictable return.

CDs generally offer higher interest rates than standard savings accounts. Longer CD terms typically offer higher rates, compensating for reduced liquidity. Funds are meant to remain untouched until maturity. Early withdrawals usually incur a penalty, which can be a forfeiture of a portion of the interest earned or even some principal, depending on the CD’s terms.

A strategy known as “CD laddering” involves purchasing multiple CDs with staggered maturity dates. For example, one might invest in 1-year, 2-year, and 3-year CDs simultaneously. As each CD matures, the funds become available for reinvestment into a new long-term CD or for other needs. This approach helps balance liquidity with the benefit of higher long-term rates.

Money Market Accounts (MMAs)

Money market accounts (MMAs) blend features of both savings and checking accounts. They typically offer higher interest rates than traditional savings accounts while providing some transactional flexibility. Competitive MMAs offer significantly higher APYs than the national average.

MMAs often come with limited check-writing privileges or debit card access, allowing for easier access to funds compared to a CD. However, they usually impose limits on monthly transactions before fees. MMAs may also require a higher minimum initial deposit or balance to earn the advertised interest rate or avoid monthly maintenance fees. Deposits are federally insured by the FDIC or NCUA.

Earning Interest Through Government Securities

Lending money to the U.S. government by purchasing Treasury securities offers another way to earn interest, considered among the safest investments due to the backing of the U.S. government. These securities come in various forms, each with distinct features regarding maturity and interest payment methods.

Treasury Bills (T-Bills)

Treasury Bills (T-Bills) are short-term debt instruments with maturities of one year or less, commonly 4, 8, 13, 26, and 52 weeks. T-Bills do not pay regular interest payments. Instead, they are sold at a discount from their face value, and the investor receives the full face value at maturity. The difference between the purchase price and face value represents the interest earned; for example, buying a $1,000 T-Bill for $980 earns $20.

Treasury Notes (T-Notes)

Treasury Notes (T-Notes) are intermediate-term government debt securities with maturities ranging from two to 10 years, commonly 2, 3, 5, 7, and 10 years. Unlike T-Bills, T-Notes pay fixed interest payments, or “coupons,” every six months until maturity. At maturity, investors receive the note’s face value. The interest rate is set at auction and remains fixed for the life of the note.

Treasury Bonds (T-Bonds)

Treasury Bonds (T-Bonds) are long-term government debt instruments with the longest maturities, typically 20 or 30 years. Similar to T-Notes, T-Bonds pay fixed interest payments semi-annually until maturity, when the investor receives the bond’s face value. T-Bonds generally offer the highest interest rates among marketable Treasury securities due to their extended maturities.

Series I Bonds (I-Bonds)

Series I Bonds are inflation-protected savings bonds designed to preserve purchasing power. Their interest rate is a composite of a fixed rate and a variable inflation rate that adjusts every six months based on the Consumer Price Index (CPI). This structure helps protect the investment from inflation. I-Bonds are available electronically through TreasuryDirect.

Series EE Bonds (EE-Bonds)

Series EE Bonds are U.S. government savings bonds earning a fixed interest rate. They are guaranteed to at least double in value over their typical 20-year initial term. EE-Bonds accrue interest monthly, compounded semi-annually, for a total of 30 years. Similar to I-Bonds, EE-Bonds are non-marketable, meaning they cannot be bought or sold in the secondary market.

Understanding Interest Income Taxation

Interest income from various sources is generally subject to taxation. Most interest received, or credited and available for withdrawal without penalty, is considered taxable income in the year it becomes available. This income is typically taxed at the federal level as ordinary income, subject to your regular income tax rate. Many states and local jurisdictions also tax interest income.

Financial institutions and other payers report interest income to both the taxpayer and the Internal Revenue Service (IRS) on specific tax forms. For instance, Form 1099-INT, “Interest Income,” is issued for interest payments of $10 or more, including interest from bank accounts, money market accounts, and certificates of deposit. This form details the interest earned and may include information on early withdrawal penalties or federal tax withheld.

When debt instruments are issued at a discount from their face value, the difference, known as Original Issue Discount (OID), is generally treated as taxable interest accruing over the obligation’s life. This income is reported on Form 1099-OID. Even without a cash payment, a prorated portion of OID may need to be reported as income each year. For sales of bonds or other securities through a broker, Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions,” is issued, reporting proceeds and helping calculate capital gains or losses.

Specific exceptions apply to interest income taxation. Interest from municipal bonds, issued by state or local governments, is generally exempt from federal income tax. If issued by the investor’s state or locality, it may also be exempt from state and local taxes. However, some municipal bonds may be subject to the Alternative Minimum Tax (AMT).

Interest income from U.S. Treasury securities is subject to federal income tax but exempt from state and local taxes. For Series I and EE Bonds, federal taxes can be deferred until redemption or maturity, and may be tax-free at the federal level if used for qualified higher education expenses, subject to income limitations. Additionally, interest earned in certain tax-advantaged accounts receives favorable tax treatment. Earnings within traditional Individual Retirement Accounts (IRAs) and 401(k) plans are tax-deferred, with taxes paid upon withdrawal in retirement. Roth IRAs and Roth 401(k)s, funded with after-tax contributions, allow for tax-free growth and withdrawals in retirement, provided certain conditions are met.

Making Informed Choices and Getting Started

Choosing the right interest-bearing products involves evaluating your financial situation and goals. Key factors should guide your decisions, ensuring accounts align with your broader financial strategy. Considering these elements helps optimize interest earnings while maintaining flexibility.

Financial goals play a central role in determining suitable interest-earning options. For short-term objectives, such as an emergency fund, high-liquidity accounts like high-yield savings accounts may be appropriate. For longer-term goals, such as saving for a home or retirement, products with potentially higher rates but less immediate access, like Certificates of Deposit or Treasury Notes, could be considered.

Liquidity needs are another important consideration. Assess how quickly you might need access to your funds. While higher interest rates are appealing, locking up money in a CD for a fixed term might not be suitable if funds are needed unexpectedly. Money market accounts offer a balance between interest earnings and accessibility, providing some check-writing privileges or debit card access.

Risk tolerance is also a factor; interest-bearing accounts are generally low-risk. Bank deposits are federally insured up to $250,000. Longer-term government securities, though safe, involve interest rate risk, meaning their market value can fluctuate before maturity. Your comfort level with potential fluctuations or access restrictions should influence your choices.

The time horizon, or how long you can commit your money, directly impacts the potential for higher returns; generally, longer commitments yield higher rates. The current interest rate environment also affects product attractiveness, favoring shorter-term or variable rates in rising markets, and fixed rates in falling markets.

Once you determine the type of interest-bearing account that suits your needs, opening one is generally straightforward. For bank accounts, you can typically open them online or in person. Required documents usually include government-issued photo identification, your Social Security Number or Taxpayer Identification Number, and proof of address. Initial funding methods often include electronic bank transfers, mobile check deposits, or mailing a check.

To purchase government securities directly, open an account through TreasuryDirect, the U.S. Treasury’s online platform. This requires your Social Security Number, a U.S. address, and a linked bank account for payments and distributions. Once established, you can select the desired security and specify the purchase amount.

After opening accounts, regularly monitor interest rates and review statements. Interest rates on variable-rate accounts can change, affecting earnings. Checking statements helps track interest earned, identify discrepancies, and ensure accurate transactions. Consistent monitoring helps maintain financial health and ensures your money works effectively.