Interest is money the bank pays you for letting them hold your deposits
When you put money in a savings account, the bank uses that money to make loans to other customers and to invest. In return, the bank pays you interest — a percentage of your balance that gets added to your account on a set schedule. The amount you earn depends on three things: how much money you have in the account, the interest rate the bank offers, and how often the bank compounds (adds) the interest.
Interest rates on savings accounts are set by each bank and change based on what the Federal Reserve does with its benchmark rate. When the Fed raises rates, banks typically raise savings rates too. When the Fed cuts rates, savings rates usually fall. The rate your bank offers today may not be the rate next month, so checking what different banks pay is worth doing before you deposit.
Key Takeaways
- Interest is calculated as a percentage of your account balance, and the rate varies by bank and changes over time based on Federal Reserve decisions.
- Most banks compound interest daily or monthly, meaning they calculate interest on your interest, which grows your balance faster than simple interest would.
- Annual Percentage Yield (APY) tells you the real return you will earn in a year when compounding is included, and it is the number to compare between banks.
- You only earn interest on money that sits in the account; withdrawals reduce your balance and the interest you earn that period.
- Some savings accounts have minimum balance requirements, and falling below them can mean losing interest or paying a fee.
How the bank calculates your interest payment
Banks use a formula based on your balance, the interest rate, and the time period. The simplest version is: Interest = Balance × Rate ÷ Number of Days in a Year × Number of Days Held. If you have $10,000 in an account earning 4.5% annual interest and you hold it for 30 days, you would earn roughly $37.50 (before compounding). But most banks do not pay you once a year — they calculate interest much more often.
The frequency matters because of compounding. When a bank compounds interest daily, it calculates what you owe on day one, adds that tiny amount to your balance, then calculates interest on the new (slightly larger) balance on day two. This repeats every day. Over months and years, earning interest on your interest adds up. A bank that compounds daily will pay you more than one that compounds monthly, even if both offer the same annual rate.
Annual Percentage Yield (APY) versus the stated interest rate
Banks must show you two numbers: the interest rate (also called the annual percentage rate or APR) and the Annual Percentage Yield (APY). The interest rate is the base percentage. The APY is the real return you will earn in a year when compounding is included. APY is always equal to or higher than the interest rate, and the difference grows the more often the bank compounds.
When you are comparing savings accounts at different banks, always compare APY to APY, not rate to rate. A bank offering 4.5% APY with daily compounding will pay you more than a bank offering 4.6% APR with monthly compounding. The bank must show you the APY in large type on any account disclosure, and online banks usually display it prominently on their website so you can compare quickly.
When and how the bank deposits your interest
Banks calculate interest on different schedules. Some calculate daily but deposit (post) the interest monthly. Others calculate and deposit daily. A few still calculate and deposit quarterly or annually, though this is less common now. The disclosure you receive when you open the account will state the compounding frequency and the posting frequency — they may not be the same.
Once interest is posted to your account, it becomes part of your balance. If you withdraw it, you lose it like any other money. If you leave it in the account, the next interest calculation includes it, so you earn interest on the interest. This is why leaving money untouched in a savings account grows faster than moving it in and out.
How your balance affects the interest you earn
Interest is calculated on your average daily balance or your ending daily balance, depending on the bank. Most banks use average daily balance, which means they add up what you had in the account each day of the month and divide by the number of days. If you had $10,000 for 15 days and $5,000 for 15 days, your average daily balance would be $7,500 for that month.
This matters when you make deposits or withdrawals. Depositing $5,000 on the last day of the month will barely affect that month's interest, but depositing it on the first day means you earn interest on it for the full month. Withdrawing money early in the month reduces the interest you earn that month more than withdrawing it late. If you need to withdraw money, timing it toward the end of the month minimizes the impact on your interest earnings.
Minimum balances and what happens if you fall below them
Some savings accounts require you to keep a minimum balance — often $500, $1,000, or $2,500 — to earn the advertised interest rate. If your balance drops below that threshold, the bank may reduce your rate to something much lower (sometimes 0.01% or less), charge you a monthly fee, or both. The account disclosure will state the minimum and what happens if you miss it.
High-yield savings accounts at online banks often have no minimum balance requirement, which is one reason they can offer higher rates — they do not have to maintain physical branches. If you have a small balance or expect to dip below a minimum sometimes, an account with no minimum requirement saves you from losing interest or paying fees.
How interest rates change and what that means for you
Savings account interest rates are not locked in. Banks change them whenever they choose, though they usually move in the same direction as the Federal Reserve's benchmark rate. When the Fed raises its rate, banks typically raise savings rates within days or weeks. When the Fed cuts its rate, banks cut savings rates, sometimes immediately.
You do not have to do anything when your rate changes — the bank will simply apply the new rate to your next interest calculation. If your bank's rate drops and you find a better rate elsewhere, you can move your money to a different bank. There is no penalty for closing a savings account and opening one somewhere else, so shopping around when rates shift is a normal part of managing savings.
Frequently Asked Questions
Can I lose money in a savings account?
No. The bank cannot reduce your balance, only the interest rate it pays. Your deposits are protected up to $250,000 per depositor per bank by the Federal Deposit Insurance Corporation (FDIC) if the bank fails. You can lose purchasing power if inflation rises faster than your interest rate, but the dollar amount in your account will not shrink.
Why do some banks pay more interest than others?
Online banks typically pay higher rates because they have lower overhead costs than brick-and-mortar banks. They do not maintain physical branches, so they pass the savings to customers through higher interest rates. Large national banks often pay lower rates because they have more branches and higher operating costs. Shopping around between online and traditional banks usually shows a significant difference.
Does interest get taxed?
Yes. Interest you earn on a savings account is taxable income. The bank will send you a 1099-INT form at the end of the year if you earned $10 or more in interest, and you must report it on your tax return. The amount you owe in taxes depends on your overall income and tax bracket.
What is the difference between a savings account and a money market account?
Money market accounts often pay slightly higher interest than savings accounts, but they usually require a higher minimum balance and limit how many withdrawals you can make per month. Savings accounts are simpler — fewer restrictions, lower minimums, and easier access to your money. The interest difference is usually small enough that a savings account makes more sense unless you have a large balance and do not need frequent access.
If I move money between my own accounts, does that affect interest?
Moving money between accounts you own at the same bank does not affect interest — the bank only cares about your balance. Moving money to a different bank does affect interest because your balance at the first bank drops. The interest you earn that month will be calculated on the lower balance, so timing large transfers toward the end of the month minimizes the impact.