Banks use one of two methods to calculate interest: simple interest or compound interest, and the method they choose determines how much money you actually earn
Most savings accounts use compound interest, which means the bank calculates interest on your balance plus any interest you've already earned. A smaller number of accounts use simple interest, which calculates interest only on your original deposit. The difference matters: with compound interest, your money grows faster because you earn interest on interest. Banks decide which method to use, and they're required to disclose it in your account agreement or on the account details page of their website.
The bank also sets the Annual Percentage Yield (APY), which is the actual rate you'll earn in a year when compound interest is factored in. This is different from the interest rate itself. The APY is what you should compare when choosing between accounts, because it shows the real return you'll get.
Key Takeaways
- Compound interest calculates interest on your balance plus previously earned interest, while simple interest calculates only on your original deposit.
- The Annual Percentage Yield (APY) is the rate you should use to compare accounts, because it includes the effect of compounding.
- Banks compound interest daily, monthly, or quarterly depending on the account, and more frequent compounding means slightly more money in your pocket.
- Your bank must show you the APY and the compounding frequency in the account disclosure document before you open the account.
How simple interest works (and why most savings accounts don't use it)
With simple interest, the bank multiplies your balance by the interest rate and pays you that amount each period. If you deposit $1,000 at 5% annual simple interest, you earn $50 per year, every year, as long as the rate stays the same. The interest never changes because it's always calculated on the original $1,000.
Simple interest is rare in savings accounts because it's not competitive. Banks use it mainly for certificates of deposit (CDs) or money market accounts at smaller institutions. Most savings accounts, especially high-yield savings accounts, use compound interest instead.
How compound interest works and why compounding frequency matters
With compound interest, the bank adds earned interest back into your balance, and then calculates the next interest payment on that larger amount. Using the same $1,000 at 5% APY compounded annually: after one year you have $1,050. In year two, the bank calculates 5% on $1,050, not $1,000, so you earn $52.50. The extra $2.50 came from earning interest on your interest.
Most banks compound interest daily, which means they calculate and add interest to your account every single day. Some compound monthly or quarterly. Daily compounding is better for you because the interest gets added more often, and you start earning interest on that new amount sooner. The difference is small on small balances, but it adds up over time and larger amounts.
Here's a concrete example: $10,000 at 4.5% APY compounded daily versus monthly, over one year. With daily compounding, you'd earn about $460. With monthly compounding, you'd earn about $459. The difference is small, but daily compounding always wins.
Where to find the compounding frequency and APY for your account
Your bank must provide the APY and compounding frequency in writing before you open the account. For online banks, this information is usually on the account details page or in a document called the "Disclosure Statement" or "Truth in Savings Act Disclosure." For brick-and-mortar banks, ask for it at the branch or find it on the bank's website under the specific account type.
The APY is always listed as a percentage and is the number you should use to compare accounts. The interest rate (sometimes called the "nominal rate") is different and lower than the APY; ignore it when comparing accounts. If your bank doesn't clearly state the APY and compounding frequency, contact them or look for another bank—they're required to provide this information.
How the interest rate affects what you earn
The APY is set by the bank and changes based on what the Federal Reserve does with its benchmark interest rate. When the Fed raises rates, banks typically raise APYs on savings accounts. When the Fed lowers rates, APYs fall. This happens because banks compete for deposits, and higher rates attract more customers.
The difference between a 0.01% APY and a 4.5% APY is enormous. On $10,000, you'd earn $1 per year at 0.01%, but $450 per year at 4.5%. This is why shopping around for the highest APY matters, especially if you have a large balance or plan to keep money in savings for years.
Your bank can change the APY at any time, and they're required to notify you before the change takes effect. Most banks notify customers by email or mail. The rate on your account may change, but the compounding method usually stays the same for the life of the account.
What happens to interest when you deposit or withdraw money mid-period
If you deposit money partway through a compounding period, the bank calculates interest on the full balance from that deposit date forward. If you withdraw money, the interest calculation adjusts for the lower balance. Banks track the daily balance and use that to calculate each day's interest, which is why daily compounding is more precise than monthly or quarterly.
Some accounts have a minimum balance requirement, and if your balance falls below it, the bank may lower your APY or charge a fee. Check your account agreement to see whether your account has this rule. If it does, keeping the minimum balance is important because dropping below it can cost you more than the interest you'd earn.
How to calculate your own interest to verify what the bank owes you
You can use the compound interest formula to check your bank's math: A = P(1 + r/n)^(nt), where A is the final amount, P is your principal (starting balance), r is the annual interest rate as a decimal, n is the number of times interest compounds per year, and t is the number of years. For $1,000 at 5% APY compounded daily for one year: A = 1000(1 + 0.05/365)^(365×1) = $1,051.27.
Most people don't need to do this calculation themselves—your bank statement shows the interest deposited each month, and you can add those up to verify the total. But if you suspect an error, the formula lets you calculate what you should have earned and compare it to what the bank actually paid.
Frequently Asked Questions
Does my bank have to tell me the APY before I open an account?
Yes. Banks must provide the APY and compounding frequency in a written disclosure before you open the account. For online accounts, this is usually on the account details page. For in-person accounts, ask the banker or request the disclosure document. If they won't provide it, that's a red flag.
Can a bank change my APY without telling me?
No. Banks must notify you before changing your APY, usually by email or mail. They can change it at any time, but the notification must come before the change takes effect. Read these notices when they arrive, because your rate may have dropped.
Is daily compounding always better than monthly?
Yes, daily compounding always earns slightly more than monthly or quarterly compounding at the same APY. The difference is small on small balances but grows with larger amounts and longer time periods. If two accounts offer the same APY, choose the one with daily compounding.
What's the difference between APY and the interest rate?
The interest rate is the base percentage the bank uses to calculate interest. The APY includes the effect of compounding, so it's always higher than the interest rate. When comparing accounts, always use the APY, not the interest rate.
If I withdraw money mid-month, do I lose all the interest I earned?
No. Banks calculate interest daily, so you earn interest up to the day you withdraw. You won't earn interest on the money after you withdraw it, but you keep what you've already earned. Some accounts have withdrawal limits or penalties, so check your agreement before withdrawing.