Banks use your account balance, the interest rate they set, and how often they compound to determine how much interest you earn

A bank calculates savings account interest by multiplying your balance by the annual interest rate, then dividing by the number of times per year interest is added to your account. That division matters because most banks add interest monthly or daily, not once a year. The more often interest is added, the more you earn—because you start earning interest on the interest itself. This is called compounding.

The formula banks use is: Interest = Balance × (Annual Rate ÷ Number of Compounding Periods). If you have $1,000 in an account earning 4% annual interest compounded monthly, the bank divides 4% by 12 to get roughly 0.33% per month. That 0.33% is applied to your $1,000, earning you about $3.30 that month. Next month, the bank applies 0.33% to $1,003.30, earning you slightly more. Over a year, daily compounding earns more than monthly compounding, which earns more than annual compounding—even at the same interest rate.

Your bank's disclosure documents (called the Truth in Savings Act disclosure) must tell you the annual percentage yield, or APY. The APY already includes the effect of compounding, so it shows you the real return you will earn in a year. The annual percentage rate, or APR, does not include compounding and is usually lower than the APY. Banks advertise the APY because it is the honest number.

Key Takeaways

  • Interest is calculated by multiplying your balance by the annual rate and dividing by how many times per year the bank adds interest to your account.
  • Daily compounding earns more than monthly compounding because interest is added more often, and you earn interest on the interest.
  • The APY (annual percentage yield) shown on your account disclosure already includes the effect of compounding and tells you the real yearly return.
  • Your balance changes daily, so banks calculate interest on the average daily balance or the ending daily balance, depending on the account terms.
  • Interest rates and compounding frequency vary by bank and account type, so comparing APY between accounts gives you the clearest picture of earnings.

How compounding frequency changes what you earn

The number of times per year a bank adds interest to your account directly affects your total earnings. If a bank compounds annually, it adds interest once a year. If it compounds monthly, it adds interest 12 times. If it compounds daily, it adds interest 365 times. Each time interest is added, the next calculation includes that new interest as part of your balance.

Consider $5,000 earning 4% APY. With annual compounding, you earn $200 in year one. With monthly compounding at the same rate, you earn about $204 because each month's interest gets added to the balance before the next month's calculation. With daily compounding, you earn roughly $204.08. The difference grows larger as your balance grows and as years pass. Over 10 years, daily compounding can earn you hundreds of dollars more than annual compounding on the same principal.

Most savings accounts today compound daily or monthly. High-yield savings accounts almost always compound daily. Money market accounts vary. Your account disclosure will state the compounding frequency. If it does not, call your bank and ask—it is a required disclosure under federal law.

Why the bank uses average daily balance or ending balance

Banks do not calculate interest on a single snapshot of your balance. Instead, they track your balance every day and use one of two methods: average daily balance or ending daily balance. The method the bank uses is stated in your account agreement.

With average daily balance, the bank adds up your balance at the end of each day during the month, then divides by the number of days. That average is what interest is calculated on. If you had $1,000 for 15 days and $2,000 for 15 days in a 30-day month, your average daily balance is $1,500. Interest is calculated on $1,500, not on whichever balance you had on the last day.

With ending daily balance, the bank calculates interest on whatever your balance is on the last day of the month. If you had $1,000 for 29 days and $2,000 on day 30, interest is calculated on $2,000. This method rewards you for deposits made late in the month. Average daily balance is more common and is generally fairer to account holders who keep steady balances.

How interest rates are set and when they change

Banks set their own interest rates based on the federal funds rate (the rate the Federal Reserve sets for banks to lend to each other) and on competition with other banks. When the Federal Reserve raises or lowers its rate, banks usually follow within days or weeks, but they are not required to. Some banks raise rates quickly and lower them slowly. Others do the opposite. There is no rule.

Savings account rates change frequently—sometimes weekly. If you see a rate advertised online, it may be different by the time you open an account. Your bank will tell you the rate when you open the account, and that rate is locked in for that account. If the bank changes its rate later, the new rate applies to all future interest earned, not retroactively to past interest.

High-yield savings accounts tend to change rates more often than traditional savings accounts because they compete directly on rate. If you want to know whether your current account's rate is still competitive, check what other banks are offering. You can move money to a higher-rate account at any time—there is no penalty for switching banks or closing an account.

The difference between APR and APY

The annual percentage rate (APR) is the interest rate before compounding. The annual percentage yield (APY) is the rate after compounding. Banks must show you both on your account disclosure, but they advertise the APY because it is the higher, more honest number.

If a bank offers 4% APR compounded daily, the APY will be slightly higher—around 4.08%—because of compounding. The difference is small at low rates but grows as rates rise. At 5% APR compounded daily, the APY is about 5.13%. When you compare savings accounts, always compare APY to APY, not APR to APY. Comparing APR to APY makes a lower-rate account look better than it actually is.

What happens to interest if you withdraw money mid-month

If you withdraw money before the end of the month, the interest calculation depends on whether your bank uses average daily balance or ending daily balance. With average daily balance, the withdrawal lowers your average, so you earn less interest that month. With ending daily balance, only the final balance matters, so a withdrawal on the 28th of a 30-day month barely affects your interest.

Some savings accounts have no withdrawal limits and no penalties, so you can move money in and out without losing interest. Others (less common now) have limits on how many withdrawals you can make per month before a fee applies. Check your account agreement or call your bank if you plan to withdraw money regularly. The interest you earn is always yours—the bank cannot take it back if you withdraw your balance.

How to track your interest earnings

Your bank sends you a monthly or quarterly statement showing the interest earned that period. Online banking portals usually show year-to-date interest earned. You can also calculate expected interest yourself using the formula: Balance × (APY ÷ 365) × Number of Days. This gives you a rough estimate for any period.

If your statement shows interest earned but you do not see it added to your balance, check whether your bank deposits interest monthly or quarterly. Some accounts add interest only once per quarter. The interest will appear as a deposit in your account on the date the bank processes it. If you do not see interest after the stated period, contact your bank—errors are rare but do happen.

Frequently Asked Questions

Does my balance have to stay the same the whole month to earn interest?

No. Banks calculate interest on your average daily balance or ending daily balance, so deposits and withdrawals during the month change how much interest you earn. With average daily balance, deposits made early in the month earn more interest than deposits made late. With ending daily balance, only your final balance matters.

Why does my APY look different from the rate the bank advertised?

Rates change frequently, sometimes weekly. The rate advertised online may have been accurate when posted but changed before you opened your account. Your bank will confirm the rate when you open the account. If the rate drops after you open it, the new rate applies only to future interest, not to interest already earned.

Can a bank change my interest rate after I open the account?

Yes. Banks can change rates on savings accounts at any time without notice (though many send an email). The new rate applies to all future interest earned. You are not locked into the original rate. If your rate drops and you want a higher rate, you can move your money to another bank's account.

What is the difference between a savings account and a money market account for interest purposes?

Both earn interest the same way—through compounding on your balance. Money market accounts often pay higher rates but may require a larger minimum balance and limit how many withdrawals you can make per month. Savings accounts are more flexible. The interest calculation method is the same for both.

If I earn $100 in interest, do I have to pay taxes on it?

Yes. Interest earned on savings accounts is taxable income. Your bank will send you a 1099-INT form at the end of the year if you earned $10 or more in interest. You report this on your tax return. The interest is taxed as ordinary income at your regular tax rate.