What a bank account that earns interest does
A bank account that earns interest pays you money based on the balance you keep in it. The bank takes deposits from many customers, lends that money out to borrowers, and shares a portion of what it makes back to you as interest. The amount you earn depends on three things: how much money sits in the account, how long it stays there, and the interest rate the bank offers.
Interest accrues—meaning it builds up—either daily, monthly, or quarterly, depending on the account. Some accounts compound interest, which means the interest you earn also starts earning interest. The longer your money sits untouched, the more it grows. This is different from a checking account, which typically pays zero interest because the bank expects you to move money in and out constantly.
Key Takeaways
- Interest rates on savings accounts vary by bank and change based on what the Federal Reserve does with its benchmark rate, so comparing rates across banks matters.
- High-yield savings accounts currently pay more interest than traditional savings accounts, though the exact rate shifts monthly.
- Money market accounts and certificates of deposit (CDs) are other ways to earn interest, each with different rules about when you can withdraw your money.
- Interest earned in a bank account is taxable income, and the bank will send you a 1099-INT form at tax time if you earn more than a small amount.
- The FDIC insures deposits up to $250,000 per account holder per bank, so your principal is protected even if the bank fails.
How interest rates work and why they change
Banks set their own interest rates, but they follow the lead of the Federal Reserve's benchmark rate, called the federal funds rate. When the Fed raises its rate, banks typically raise the rates they pay on savings accounts. When the Fed cuts its rate, banks cut theirs. This means the interest rate you see today may not be the same rate you see in three months.
Online banks and credit unions often pay higher rates than brick-and-mortar banks because they have lower overhead costs. A traditional bank might pay 0.01% annual interest on a savings account, while an online bank might pay 4% or 5%. The difference is real and compounds over time. If you have $10,000 in a traditional account earning 0.01%, you make $1 per year. In a high-yield account earning 4.5%, you make $450 per year on the same money.
Interest rates are not locked in. Banks can change the rate they pay on your account at any time, usually with notice. Some accounts have a promotional rate that applies for a limited time, then drop to a lower ongoing rate. Read the fine print before opening an account so you know whether the rate you see is permanent or temporary.
Types of interest-bearing accounts and how they differ
A high-yield savings account works like a regular savings account but pays significantly more interest. You can deposit and withdraw money whenever you want, though some banks limit the number of withdrawals per month. There is no maturity date—the account stays open as long as you want it to.
A money market account is a hybrid between a checking and savings account. It typically pays higher interest than a regular savings account but lower than a high-yield savings account. Many money market accounts come with a debit card or checks, so you can access your money more easily. Some require a higher minimum balance to open.
A certificate of deposit (CD) is an account where you agree to leave your money untouched for a set period—three months, six months, one year, or longer. In exchange, the bank pays you a higher interest rate than it would for a regular savings account. If you withdraw the money before the term ends, you pay a penalty, usually a few months' worth of interest. CDs are useful if you know you will not need the money for a specific time and want a may provide rate.
How to calculate what you will earn
Banks use the annual percentage yield (APY) to show you how much interest you will earn in a year, accounting for compounding. This is different from the annual percentage rate (APR), which does not include compounding. Always compare APY, not APR, when looking at savings accounts.
To estimate your earnings, multiply your balance by the APY. If you have $5,000 in an account paying 4.5% APY, you will earn roughly $225 in a year, assuming the rate does not change and you do not add or withdraw money. If you add money throughout the year, your earnings will be higher. If the bank cuts the rate, your earnings will be lower.
Some banks calculate interest daily and deposit it monthly, which means your balance grows slightly each day. Others calculate monthly or quarterly. Daily compounding is better for you because your interest starts earning interest sooner, but the difference is usually small unless you have a large balance.
Tax implications of interest income
Interest you earn is taxable income. You must report it on your federal tax return, and depending on your state, you may owe state income tax on it too. If you earn $10 or more in interest during a calendar year, the bank will send you a Form 1099-INT by January 31 of the following year. You use this form to report the income to the IRS.
If you earn less than $10, the bank may not send a 1099-INT, but you are still required to report the income if you file a tax return. Keep your own records of interest earned if the amount is small. The IRS matches 1099-INT forms to tax returns, so reporting it correctly matters.
FDIC protection and what happens if the bank fails
The Federal Deposit Insurance Corporation (FDIC) insures deposits at most banks up to $250,000 per depositor per bank. This means if the bank fails, the FDIC will reimburse you for your balance up to that limit. The insurance covers the principal plus any interest you have earned.
If you have more than $250,000 at one bank, only the first $250,000 is protected. If you want to protect more money, you can open accounts at different banks—each bank's FDIC coverage is separate. Some account types, like joint accounts, have separate coverage limits, so a joint account with your spouse gets its own $250,000 protection in addition to your individual account's protection.
When to use an interest-bearing account versus other options
An interest-bearing account makes sense for money you want to keep safe and accessible but do not need to spend right away. This includes emergency funds, money saved for a down payment, or funds set aside for a known expense a year or two from now. The interest is a bonus on top of the safety and liquidity.
If you need the money within a few months, a high-yield savings account is better than a CD because you can withdraw without penalty. If you know you will not touch the money for a year or longer, a CD might pay a higher rate. If you want to earn more than a savings account pays but are willing to take some risk, you might consider stocks or bonds instead, though those are not insured by the FDIC.
Do not use an interest-bearing account as your primary checking account. You will earn almost nothing on money you are constantly moving in and out, and the restrictions on withdrawals or minimum balances may frustrate you. Keep a checking account for daily spending and an interest-bearing account for money you are saving.
How to open an interest-bearing account
Most banks let you open an account online in minutes. You will need to provide your name, address, Social Security number, and date of birth. The bank will verify your identity and check your banking history through ChexSystems, a database that tracks account closures and fraud. If you have a history of overdrafts or fraud, some banks may deny you.
Once your account is open, you can deposit money by transferring it from another bank account, mailing a check, or using a debit card if the bank offers that option. Some banks require a minimum opening deposit, often $25 to $100, though many online banks have no minimum. Read the account terms to see what fees apply—some accounts charge monthly fees if your balance falls below a certain amount, though many online banks charge no fees at all.
Frequently Asked Questions
Can I withdraw money from a savings account anytime I want?
Yes, from a high-yield savings account or traditional savings account. Some banks limit the number of withdrawals per month, though this is less common now. CDs are different—you pay a penalty if you withdraw before the term ends. Money market accounts usually allow withdrawals but may limit how many you can make per month.
What is the difference between APY and APR?
APY includes the effect of compounding, so it shows the true amount you will earn over a year. APR does not include compounding. Always compare APY when looking at savings accounts. For example, an account might advertise 4.5% APR but 4.6% APY because of daily compounding.
Do I have to pay taxes on interest I earn?
Yes, interest is taxable income. If you earn $10 or more in a year, the bank sends you a 1099-INT form to report to the IRS. You report this on your tax return. Even if you earn less than $10, you should report it if you file a return.
What happens to my money if the bank goes out of business?
The FDIC insures deposits up to $250,000 per depositor per bank. If the bank fails, the FDIC reimburses you for your full balance up to that limit, including any interest earned. Your money is protected.
Should I put all my savings in a CD to earn the highest rate?
Only if you will not need the money before the CD matures. If you withdraw early, you pay a penalty that can wipe out months of interest. For emergency funds or money you might need soon, a high-yield savings account is safer because you can access it without penalty.