Banks multiply your balance by an interest rate, then divide by the number of days in a year

Most savings accounts use daily compounding, which means the bank calculates interest on your balance every single day, then adds that interest to your account. The next day, the bank calculates interest on the new, slightly larger balance. This repeats every day, so your money grows a little faster than it would with simple interest.

The actual formula banks use is: (Your balance × Annual interest rate) ÷ 365 = Interest earned that day. If your balance is $10,000 and the annual rate is 4.50%, you earn about $1.23 that day. Tomorrow, if nothing changes, you earn interest on $10,001.23 instead of $10,000.

The interest rate itself—called the Annual Percentage Yield (APY)—is what the bank advertises. This rate changes based on what the Federal Reserve does with its benchmark rate. When the Fed raises rates, banks raise savings account rates. When the Fed cuts rates, banks cut them too, usually within days.

Key Takeaways

  • Daily compounding means the bank calculates interest every day and adds it to your balance, so you earn interest on your interest.
  • The Annual Percentage Yield (APY) is the rate the bank shows you; it already accounts for daily compounding.
  • Your actual interest earned depends on your balance, the APY, and how many days the money sits in the account.
  • Banks can change the APY at any time, and most do within days when the Federal Reserve changes its rates.

Why the APY matters more than the interest rate

Banks sometimes list two different numbers: the interest rate and the APY. The APY is the one that matters to you. The interest rate is the base number; the APY is what you actually earn after compounding is factored in.

For example, a bank might say "4.50% APY" on a savings account. That 4.50% already includes the effect of daily compounding. You do not have to do any math—just know that if you leave $10,000 in the account for a full year with no deposits or withdrawals, you will have about $10,450 at the end (before taxes).

The difference between a rate and an APY is small on savings accounts but real. A 4.50% APY might be based on a 4.49% interest rate, with the extra 0.01% coming from compounding. On large balances or over many years, that difference adds up.

How balance changes affect what you earn

The bank calculates interest on your actual balance each day. If you deposit $5,000 on the 15th of the month, you earn interest on that $5,000 starting the 15th. If you withdraw $2,000 on the 20th, your balance drops and so does the interest you earn each day going forward.

This is why the timing of deposits and withdrawals matters. Depositing early in the month means your money earns interest for more days. Withdrawing late in the month means you keep earning on a larger balance for longer. The difference is usually small—a few dollars on a typical account—but it is real.

Some banks use a method called "average daily balance," where they add up your balance for each day of the month and divide by the number of days. Most online banks use daily compounding instead, which is simpler and usually pays slightly more.

When interest actually hits your account

Banks calculate interest daily, but they deposit it into your account on a schedule—usually monthly. You might see interest posted on the last day of the month or the first day of the next month. Some banks post it quarterly or even annually, though this is rare for savings accounts.

The day interest posts matters for compounding. If interest posts on the last day of the month, it starts earning interest itself the next day. If you withdraw money the day before interest posts, you lose that month's interest entirely on most accounts.

Check your account statement or the bank's website to see when interest posts. The timing is usually consistent month to month, so you can plan around it if you need to make a large withdrawal.

How to compare interest rates between banks

Always compare APY, not the interest rate. The APY is the standardized number that lets you see which bank pays more. A bank advertising "4.50% APY" pays more than one advertising "4.45% APY," even if the difference sounds tiny.

On a $10,000 balance, that 0.05% difference is about $5 per year. On a $100,000 balance, it is about $50 per year. Over five years, small differences compound into real money.

Online banks usually pay higher APYs than brick-and-mortar banks because they have lower overhead costs. Credit unions sometimes pay competitive rates too. Check sites that list current rates across multiple banks—they update daily as rates change.

What happens when the Federal Reserve changes rates

The Federal Reserve does not set savings account rates directly. Instead, it sets a target range for the federal funds rate, which is the rate banks charge each other to borrow overnight. When the Fed raises or lowers this rate, banks adjust their savings account APYs in response.

Banks usually raise savings rates within days of a Fed increase, because they want to attract deposits. They cut rates much faster than they raised them when the Fed cuts—sometimes within hours. This is because banks make money on the difference between what they pay depositors and what they charge borrowers.

If you have money in a savings account and the Fed is expected to cut rates, moving money into a high-yield account before the cut happens can lock in a higher rate for a few more months. Once rates drop, your APY will drop too, but the interest you already earned stays in your account.

How taxes affect your interest earnings

Interest from a savings account is taxable income. The bank reports it to the IRS on a Form 1099-INT if you earn $10 or more in a year. You owe federal income tax on that interest at your regular tax rate.

Some states also tax savings account interest. A few states exempt it for residents over a certain age or with lower incomes. Check your state's tax rules or ask your bank whether your interest is subject to state tax.

The interest is taxed in the year it is earned, not the year you withdraw it. If interest posts to your account in December, you owe tax on it that year, even if you do not touch the money until January.

Frequently Asked Questions

Do I earn interest on interest in a savings account?

Yes. With daily compounding, interest posted to your account starts earning interest the next day. This is called compound interest. Over time, compounding makes your balance grow faster than simple interest would, though the difference is usually small on savings accounts.

Can a bank change my interest rate without warning?

Yes. Banks can change savings account rates at any time without notice. Most online banks change rates within days of a Federal Reserve decision. You should check your rate periodically or set up alerts if your bank offers them.

What is the difference between APY and APR?

APY (Annual Percentage Yield) is used for savings accounts and shows what you earn. APR (Annual Percentage Rate) is used for loans and credit cards and shows what you pay. For savings, always look at APY.

If I withdraw money mid-month, do I lose all the interest?

No. You earn interest on your balance for each day the money is in the account. If you withdraw on the 15th, you earn interest for the first 14 days. Interest posts on the bank's schedule, usually monthly, so timing matters slightly—but you do not lose everything.

Why do online banks pay higher interest than traditional banks?

Online banks have lower costs because they do not operate physical branches. They pass some of those savings to customers through higher interest rates. Traditional banks pay lower rates partly because they maintain branch networks and staff.