Interest is money the bank pays you for letting them use your deposits

When you put money in a savings account, the bank lends that money to other customers through mortgages, car loans, and business lines of credit. In exchange, the bank pays you interest — a percentage of your balance that gets added to your account on a regular schedule. The more money you keep in the account and the longer you keep it there, the more interest you earn.

The interest rate your bank offers depends on the current market — when the Federal Reserve raises rates, banks typically raise the rates they pay on savings accounts. When rates fall, so do the rates banks offer. Your specific rate also depends on the type of account you open and the bank itself. Some banks pay much higher rates than others, even when market conditions are the same.

Interest compounds, meaning you earn interest on your interest. If your account earns $10 in interest one month, the next month you earn interest on your original balance plus that $10. Over time, compounding makes your money grow faster than simple addition would suggest.

Key Takeaways

  • Banks pay interest as a percentage of your account balance, calculated daily or monthly depending on the account and bank.
  • The interest rate changes based on what the Federal Reserve does and what each individual bank decides to offer.
  • Interest compounds, so you earn money on the interest you already earned, which accelerates growth over time.
  • You can compare rates across banks before opening an account — online banks often pay higher rates than brick-and-mortar branches.
  • Interest is taxable income, and you will receive a 1099-INT form from your bank if you earn $10 or more in a calendar year.

How the interest rate is set and when it changes

The Federal Reserve sets a target interest rate range that influences how much banks charge each other to borrow money overnight. This rate, called the federal funds rate, indirectly affects the rates banks offer on savings accounts. When the Fed raises its target rate, banks raise the rates they pay on savings. When the Fed lowers its target rate, banks lower the rates they pay.

However, banks do not all move at the same speed or to the same degree. A large national bank might take weeks to raise its savings rate after a Fed increase, while an online bank might raise its rate within days. Some banks raise rates quickly but lower them slowly. Others do the opposite. This is why two banks can offer very different rates on the same day, even though they are both responding to the same Fed decision.

Your bank can also change your rate at any time without your permission, though most banks give you notice before lowering a rate. If your bank lowers the rate on your account, you can move your money to a different bank that offers a higher rate — there is no penalty for switching savings accounts.

How banks calculate the interest you earn

Banks use one of two methods to calculate interest: daily balance or monthly balance. Most savings accounts use daily balance, which means the bank calculates how much interest you earn based on your balance every single day, then adds up all those daily amounts at the end of the month.

Here is how daily balance works in practice. Suppose your account earns 4.5% annual interest. The bank divides that by 365 days to get a daily rate of about 0.0123%. If your balance is $10,000 on Monday, you earn about $1.23 that day. If you deposit $5,000 on Tuesday, your new balance is $15,000, and you earn about $1.85 that day. At the end of the month, the bank adds up all the daily interest amounts and deposits the total into your account.

Monthly balance is simpler but less common. The bank looks at your balance on the last day of the month and calculates interest based only on that number. If you had $10,000 most of the month but withdrew it on the last day, you would earn almost no interest that month, even though you had the money for most of the period. Daily balance is fairer because you earn interest on every dollar for every day it sits in the account.

How often interest is deposited into your account

Banks deposit interest into your account on different schedules depending on the account and the bank. Most savings accounts compound and deposit interest monthly — the bank adds your earned interest to your balance on the same day each month, usually the first or the last day. Some accounts compound daily but deposit monthly, meaning interest accrues every day but you do not see it in your account until the end of the month.

A few accounts compound and deposit quarterly (every three months) or annually (once a year). The more frequently interest is deposited, the faster your money grows, because you start earning interest on that interest sooner. Monthly is standard for most savings accounts. High-yield savings accounts almost always compound and deposit monthly.

When you open an account, the bank will tell you the compounding and deposit schedule in the account disclosure document. You can also call the bank or check its website to confirm how often interest is added.

Annual Percentage Yield versus annual percentage rate

Annual Percentage Yield (APY) is the rate that matters for savings accounts. APY includes the effect of compounding, so it shows you the actual percentage of growth you will see in a year. If a bank advertises 4.5% APY, that means if you deposit $10,000 and leave it untouched for one year, you will have $10,450 at the end (assuming the rate does not change).

Annual Percentage Rate (APR) is used for loans and credit cards, not savings accounts. APR does not account for compounding. Banks are required to show you the APY, not the APR, when you are shopping for a savings account, so you should always look for the APY number.

When comparing accounts at different banks, always compare APY to APY. A bank that compounds daily might show a slightly higher APY than a bank that compounds monthly, even if the stated interest rate is the same, because daily compounding grows your money a tiny bit faster.

Why interest rates vary so much between banks

Online banks typically offer higher interest rates than brick-and-mortar banks because they have lower overhead costs. They do not pay for physical branches, tellers, or as many employees. They pass those savings on to customers by paying higher rates on savings accounts. A national bank with hundreds of branches might offer 0.01% APY on a savings account, while an online bank offers 4.5% APY on the same day.

Banks also use interest rates as a marketing tool. A new online bank might offer an unusually high rate for the first few months to attract customers, then lower the rate once it has built a customer base. Some banks offer higher rates only on accounts with large minimum balances or accounts that meet other conditions, like setting up direct deposit.

Credit unions, which are member-owned rather than shareholder-owned, sometimes offer higher rates than banks because they do not have to generate profits for investors. However, credit unions are not insured by the Federal Deposit Insurance Corporation (FDIC) — they are insured by the National Credit Union Administration (NCUA), which provides the same protection up to $250,000 per account.

What happens to your interest if you withdraw money early

Withdrawing money from a savings account does not trigger a penalty or forfeit your interest. You keep all the interest you have already earned. However, you stop earning interest on the money you withdraw once it leaves the account.

If you withdraw $5,000 from a $10,000 balance on the 15th of the month, you will earn interest on the full $10,000 for the first 15 days, then interest on the remaining $5,000 for the rest of the month. The interest you earned on the $5,000 you withdrew is yours to keep.

Some accounts, like money market accounts or certificates of deposit (CDs), do have withdrawal penalties or restrictions. A standard savings account does not. You can move money in and out without losing any interest you have already earned.

How interest income is taxed

Interest you earn on a savings account is taxable income. You must report it on your federal tax return, and depending on your state, you may also owe state income tax on it.

If you earn $10 or more in interest during a calendar year, your bank will send you a Form 1099-INT by January 31 of the following year. You use this form to report the interest on your tax return. If you earn less than $10, the bank does not send a form, but you still owe tax on the interest — you have to report it yourself.

The tax rate you pay on interest depends on your overall income and tax bracket. Interest is taxed as ordinary income, not at the lower capital gains rate. If you are in the 24% tax bracket and earn $100 in interest, you will owe about $24 in federal income tax on that interest (before accounting for deductions or credits).

Frequently Asked Questions

How much interest will I earn on $10,000 in a savings account?

It depends on the interest rate and how long the money stays in the account. At 4.5% APY, $10,000 earns about $450 in one year. At 0.01% APY, it earns about $1. Rates vary widely between banks, so compare rates before opening an account.

Can I lose money in a savings account?

No. Your deposits are insured by the FDIC up to $250,000 per account per bank. You will not lose your principal. However, if inflation is higher than your interest rate, your money loses purchasing power — it buys less than it did before.

Is interest paid monthly or annually?

Most banks deposit interest monthly, though some deposit quarterly or annually. Check your account disclosure or call your bank to confirm the schedule. Monthly deposits are most common.

What if I move my money to a different bank — do I lose the interest I already earned?

No. You keep all interest you have already earned. When you transfer money to a new bank, you receive the full balance including all accrued interest. You only stop earning interest once the money leaves your old account.

Do I have to report interest under $10 on my taxes?

Yes. Even if your bank does not send a 1099-INT form because you earned less than $10, you still owe tax on that interest and must report it on your tax return.