What Is Earned Interest and How Does It Work?
Learn what earned interest is and how this fundamental financial concept helps your money grow, building your wealth over time.
Earned interest is the compensation received for allowing another party to use one’s money. It functions as the cost of borrowing for the borrower and a reward for the lender or saver. Understanding how interest accrues and its various forms is important for managing personal financial resources effectively.
Defining Earned Interest
Earned interest is the monetary return an individual receives for depositing funds into an account or lending money. The interest rate, expressed as a percentage, determines how much interest will be paid on the principal over a specified period. For example, a savings account might offer an annual interest rate of 0.50% on the deposited balance.
The calculation of interest involves multiplying the principal amount by the interest rate and the time period. This compensates the lender for the opportunity cost of not having access to their funds and for the risk associated with lending. Financial institutions pay interest to depositors to attract and retain funds, which they then lend out to others at a higher rate. This difference in rates forms a core part of their business model.
How Interest Grows
Interest can grow in two ways: through simple interest or compound interest. Simple interest is calculated solely on the original principal amount of a deposit or loan. For instance, if someone deposits $1,000 in an account earning 5% simple interest annually, they would earn $50 in interest each year.
Compound interest is calculated on the initial principal and also on the accumulated interest from previous periods. This method is often referred to as “interest on interest” because the earned interest itself begins to earn interest. For example, if the same $1,000 earns 5% compound interest annually, the first year would yield $50 in interest. In the second year, the 5% interest would be calculated on $1,050, resulting in $52.50 of interest for that year. This compounding effect causes the total amount of money to grow at an accelerating rate over time, leading to larger returns compared to simple interest over longer periods.
Common Sources of Earned Interest
Individuals commonly earn interest from various financial products. Savings accounts are a widespread source, paying a small percentage on deposited funds, often monthly or quarterly. These accounts offer liquidity, allowing easy access to funds while they accrue interest. Certificates of Deposit (CDs) are another option, where funds are locked in for a fixed period, ranging from a few months to several years, in exchange for a higher interest rate than standard savings accounts.
Money market accounts provide interest earnings, often at rates higher than traditional savings accounts, while also offering check-writing privileges or debit card access. Bonds represent another source of earned interest. When an individual purchases a bond, they are lending money to a government entity, such as the U.S. Treasury, or a corporation. In return, the bond issuer promises to pay regular interest payments, known as coupon payments, over the bond’s life, and to return the original principal amount at maturity.
Tax Implications of Earned Interest
Earned interest is considered taxable income by federal and state governments. When interest is earned, financial institutions report these earnings to both the account holder and the Internal Revenue Service (IRS). This reporting is done using Form 1099-INT, “Interest Income,” which details the total amount of interest earned in a calendar year. Individuals must then report this income on their annual tax returns, typically on Schedule B (Form 1040), “Interest and Ordinary Dividends.”
While most interest is taxable, there are exceptions. Interest earned from certain municipal bonds, issued by state and local governments, may be exempt from federal income tax. Interest from municipal bonds issued within one’s own state may also be exempt from state and local taxes in that state. Interest earned within tax-advantaged retirement accounts, such as an Individual Retirement Arrangement (IRA) or 401(k), is typically tax-deferred, meaning taxes are not paid until retirement, or potentially tax-free under specific conditions, as with a Roth IRA.