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

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 set schedule. The rate the bank offers you is called the annual percentage yield, or APY. It tells you what percentage of your balance you'll earn over one year if you don't withdraw anything.

The amount you actually earn depends on three things: how much money you have in the account, what APY the bank is offering, and how long your money sits there. A $5,000 balance at 4.5% APY earns a different amount than a $5,000 balance at 0.01% APY — and both are different from what you'd earn if you withdrew half the money partway through the year.

Banks are required to tell you the APY before you open an account, and they must show it clearly on statements and online. The APY already includes the effect of how often the bank compounds your interest (explained below), so you don't have to do separate math for that part.

Key Takeaways

  • Interest is calculated as a percentage of your account balance and paid to you by the bank on a regular schedule, usually monthly or daily.
  • The APY (annual percentage yield) tells you the total percentage you'll earn in a year and already includes compounding, so it's the number to compare between banks.
  • Interest rates on savings accounts vary widely by bank and change over time, so a 4.5% APY today might be 2.0% next year.
  • The more money you keep in the account and the longer you leave it there, the more interest you earn, but you can withdraw your balance at any time without penalty.

How banks calculate interest: daily balance and compounding

Most banks calculate interest using your daily balance — they add up how much money you had in the account each day of the month, then divide by the number of days to get an average. They then apply the APY to that average balance to figure out how much interest you've earned that month. If you had $10,000 for 15 days and $8,000 for the remaining 15 days of a 30-day month, your average balance would be $9,000.

Once the bank calculates the interest you've earned, it adds that money back into your account. This is called compounding. The next month, the bank calculates interest on your original balance plus the interest you just earned. Over time, this means you earn interest on your interest, which is why accounts with higher APYs and longer holding periods grow faster. A $10,000 balance at 4.5% APY compounds monthly and grows to roughly $10,459 after one year, while the same balance at 0.01% APY grows to only $10,001.

Some banks compound interest daily, some weekly, and some monthly. The APY already accounts for this difference, so you don't need to calculate it yourself — the APY is what you'll actually earn. A bank advertising 4.5% APY will deliver 4.5% whether it compounds daily or monthly.

When and how often interest gets added to your account

Banks add interest to your account on different schedules depending on the bank and account type. Most common savings accounts receive interest monthly — on the same day each month, or on the last business day of the month. Some high-yield savings accounts compound and credit interest daily, meaning you see the deposit every single day, though the amount each day is tiny. A few accounts credit interest quarterly (every three months) or annually (once a year).

You can see when interest was added by looking at your account statement or transaction history online. The deposit will show up as a credit with a label like "Interest Paid" or "Interest Credited." If you don't see interest appearing, check your APY — if it's 0.01% or lower, the monthly amount might be less than a penny and won't show as a separate transaction.

The schedule doesn't change how much you earn over a year. Whether interest is added daily or monthly, the APY remains the same. The only practical difference is that daily compounding means your balance grows slightly faster because each day's interest starts earning interest the next day, rather than waiting until the end of the month.

Why APY varies between banks and over time

Banks set their own APY based on what the Federal Reserve charges them to borrow money, what they can earn by lending to customers, and how much competition they face for deposits. Online banks typically offer higher APYs than brick-and-mortar banks because they have lower overhead costs. During periods when the Federal Reserve raises its benchmark interest rate, most banks raise their savings APYs within weeks. When the Fed lowers rates, banks usually lower their APYs shortly after.

The APY you see advertised today may not be the rate you lock in forever. Banks can change the rate on savings accounts at any time without your permission, though they must notify you before the change takes effect. If your bank lowers the rate from 4.5% to 2.0%, your balance doesn't shrink — you simply earn less interest going forward. You're free to move your money to a different bank offering a higher rate.

Checking the APY before opening an account matters because the difference between 4.5% and 0.5% adds up quickly on larger balances. On a $50,000 balance held for one year, the difference between those two rates is roughly $2,000 in interest earned.

What happens to interest if you withdraw money mid-month

If you withdraw money from your savings account before the month ends, the bank recalculates interest based on your actual daily balance, not what you started with. If you had $10,000 for 20 days and then withdrew $5,000, leaving $5,000 for the remaining 10 days, the bank uses that lower average balance to calculate that month's interest. You don't lose interest you've already earned in previous months — only the current month's interest is recalculated.

This is different from certificates of deposit (CDs), where withdrawing early usually triggers a penalty. Savings accounts have no withdrawal penalty, so you can take money out whenever you need it without losing interest you've already received. The tradeoff is that savings accounts typically offer lower APYs than CDs because the bank can't count on your money staying put.

How to compare interest rates between banks

When shopping for a savings account, always compare the APY, not just the interest rate. The APY is the standardized number that already includes compounding, so it's the only fair way to compare. A bank advertising "4.5% interest rate compounded daily" and another advertising "4.5% APY" are offering the same thing — the APY is just the clearer way to state it.

Look at the APY in writing before you open the account. Banks must disclose it in the account agreement and on any marketing materials. Online banks often display the current APY prominently on their website. If you're comparing accounts at a brick-and-mortar bank, ask the teller or banker for the APY in writing — don't rely on what's posted in the lobby, because rates change frequently.

Keep in mind that the highest APY today might not be the best account for you if it comes with monthly fees, minimum balance requirements, or limited withdrawal options. A 4.5% APY with a $25,000 minimum balance and a $10 monthly fee might earn you less than a 4.0% APY with no minimums and no fees, depending on your balance.

Interest and taxes: what you need to know

Interest you earn on a savings account is taxable income. At the end of each year, your bank sends you a Form 1099-INT showing how much interest you earned. You report this amount on your federal tax return, and you may owe income tax on it depending on your total income and tax bracket.

The bank doesn't withhold taxes from interest payments — you're responsible for setting aside money to pay taxes on what you earn. If you earn more than $10 in interest during the year, the bank is required to send you the 1099-INT form. If you earn less than $10, the bank may not send a form, but you still owe tax on the interest if you're required to file a return.

Some people open savings accounts specifically to hold money for a short time before moving it elsewhere. The interest earned during that time, even if it's just a few dollars, is still taxable income and must be reported.

Frequently Asked Questions

Can I earn interest on money I just deposited?

Yes. Interest accrues from the day the deposit clears your bank's system, not from the day you made the deposit. If you deposit money on a Friday and it clears Monday, interest starts accruing Monday. The bank includes that day in the daily balance calculation for the month.

What if my bank's APY drops after I open the account?

The bank can lower the APY on your account at any time. They must notify you before the change takes effect, usually by email or mail. Your existing balance doesn't change — you simply earn less interest on new deposits and on your existing balance going forward. You can move your money to a different bank if the new rate is too low.

Is the interest I earn the same every month?

No. The amount of interest you earn each month depends on your average daily balance that month. If you deposit a large sum mid-month, the next month's interest will be higher. If you withdraw money, the following month's interest will be lower. The APY stays the same, but the dollar amount changes based on your balance.

Do I have to do anything to get the interest deposited into my account?

No. Interest is deposited automatically on the schedule your bank uses — usually monthly. You don't need to request it or take any action. You can see it appear in your account history and on your statement.

What's the difference between APY and APR?

APY (annual percentage yield) includes the effect of compounding and is used for savings accounts and CDs. APR (annual percentage rate) does not include compounding and is used for loans and credit cards. When comparing savings accounts, always use the APY number.