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

When you put money in a savings account, the bank lends that money to other customers — for mortgages, car loans, business loans, and other purposes. In exchange for using your money, the bank pays you interest, which is a percentage of your balance. The longer your money sits in the account, and the higher your balance grows, the more interest you earn.

The amount of interest you earn depends on two things: the interest rate the bank offers, and how often the bank compounds your interest — meaning how often it calculates interest on your interest. A bank might offer 4% annual interest compounded daily, for example, which means it calculates and adds interest to your account every single day, and each day's calculation includes the interest you earned the day before.

Interest rates vary widely between banks and change over time based on what the Federal Reserve does with its own rates. A savings account at one bank might earn 4.5% while another earns 0.01%. The difference matters: on a $10,000 balance, the higher rate would earn you roughly $450 per year while the lower rate would earn you $1.

Key Takeaways

  • Banks pay you interest on savings account balances because they lend your money to other customers.
  • The interest rate varies by bank and changes over time, so comparing rates before opening an account can significantly affect how much you earn.
  • Interest compounds — meaning interest is calculated on your interest — and more frequent compounding means slightly more money in your account.
  • Online banks typically offer higher interest rates than brick-and-mortar banks because they have lower operating costs.
  • You pay income tax on the interest you earn, and the bank will send you a tax form (1099-INT) if your interest exceeds $10 in a year.

Why interest rates differ between banks

Banks set their own interest rates based on their costs and competition. An online bank with no physical branches has lower expenses than a bank with hundreds of locations, so it can afford to pay you more interest. A bank in a competitive market where many other banks are nearby might offer higher rates to attract new customers. A bank with plenty of deposits already might offer lower rates because it does not need to attract more money.

The Federal Reserve also influences all interest rates in the economy. When the Fed raises its own rates, banks typically raise the rates they pay on savings accounts. When the Fed lowers its rates, banks usually lower savings rates too. This means the interest rate you see today may be different in six months.

Some banks offer promotional rates — temporarily higher interest rates for new customers or for the first few months. These rates often drop after the promotional period ends, sometimes to rates much lower than what you started with. Read the fine print to understand when and how the rate changes.

How compounding affects the money you earn

Compounding means the bank calculates interest on your interest. If your account compounds daily, the bank adds a small amount of interest to your balance every day. The next day, it calculates interest on the new, slightly larger balance — including the interest from the day before. Over a year, this adds up to more money than if interest were calculated only once.

The difference between daily compounding and monthly compounding is small on most savings account balances, but it exists. On a $10,000 balance at 4% annual interest, daily compounding might earn you about $408 over a year, while monthly compounding might earn you about $407. The difference grows larger as your balance grows larger.

Most savings accounts compound daily, and many banks advertise this fact. If a bank does not mention compounding, you can ask them directly or check their account disclosure document, which they are required to provide before you open the account.

Where to find current interest rates

You can compare savings account rates on financial websites like Bankrate, DepositAccounts, or NerdWallet. These sites let you filter by bank type (online, national, local), sort by interest rate, and see which banks are currently offering the highest rates. The rates update regularly as banks change their offerings.

You can also visit individual bank websites directly. Most banks display their current savings rates prominently on their homepage or in an account details section. If you see a rate advertised but cannot find it on the website, call the bank's customer service line — the advertised rate may explore only to new customers, or only to balances above a certain amount.

When comparing rates, also check the minimum balance requirement. Some banks offer high interest rates only if you keep a certain amount in the account — perhaps $2,500 or $25,000. If your balance falls below that minimum, the rate drops significantly. Make sure the rate you are comparing applies to the balance you actually plan to keep.

What happens to interest when you withdraw money

Interest is calculated based on your balance during the period when the interest is earned. If you have $5,000 in your account for most of the month, then withdraw $2,000 on the last day, the bank calculates interest based on the average balance or the balance on specific dates, depending on the bank's method. You earn less interest that month because your balance was lower.

Some savings accounts have withdrawal limits or fees if you withdraw too often. Federal law used to limit savings account withdrawals to six per month, but that rule was suspended. However, individual banks may still impose their own limits or charge a fee for excess withdrawals. Check your account agreement to understand your bank's withdrawal policy.

If you need to withdraw money regularly, a money market account might work better than a savings account. Money market accounts often have higher interest rates and allow more frequent withdrawals, though they may require a higher minimum balance.

How interest is taxed

Interest you earn on a savings account is considered income, and you owe federal income tax on it. If your interest earnings are $10 or more in a calendar year, the bank sends you a form called a 1099-INT in January of the following year. You report this interest on your tax return.

The amount of tax you owe depends on your total income and your tax bracket. If you earn $500 in interest and you are in the 22% tax bracket, you owe roughly $110 in federal income tax on that interest. Some states also tax interest income, so check your state's rules.

You do not pay tax on the interest until you file your tax return — the bank does not withhold it automatically. This means if you earn interest in 2024, you report it on your 2024 tax return, which you file in early 2025. Keep track of your interest earnings throughout the year so you are not surprised when you file.

High-yield savings accounts versus regular savings accounts

A high-yield savings account is straightforward a savings account that pays a higher interest rate than a regular savings account. There is no official definition — one bank's "high-yield" account might pay 4.5% while another bank's regular savings account pays 4.3%. The term is marketing language, not a legal category.

High-yield accounts are almost always offered by online banks, which have lower costs and can afford to pay more. They work exactly like regular savings accounts: you deposit money, earn interest, and can withdraw whenever you want. The main difference is the interest rate.

The trade-off is that high-yield accounts sometimes have higher minimum balance requirements, or they may not offer as many branches or customer service options as a traditional bank. If you value being able to walk into a physical location and speak to someone in person, a local bank's regular savings account might be worth accepting a lower interest rate.

Frequently Asked Questions

Can I move my money to a different bank if interest rates go up?

Yes. You can open a new savings account at any bank and transfer your money there. There is no penalty for moving your savings. The only cost might be a wire transfer fee if you move a large amount, though many banks waive this fee. You can keep your old account open or close it — the choice is yours.

What if my bank lowers its interest rate?

Banks can lower interest rates at any time, and they do not need your permission. You will usually receive notice before the change takes effect. If the new rate is too low, you can move your money to a different bank. There is no penalty for switching banks or closing an account.

Does interest compound on money I just deposited?

Yes, interest starts accruing as soon as the deposit clears in your account. If you deposit $1,000 on the 15th of the month, the bank begins calculating interest on that $1,000 when ready. The interest you earn that month will be less than a full month's worth because the money was not in the account for the entire month.

Is there a limit to how much interest I can earn?

No. You can earn as much interest as your balance and the interest rate allow. There is no cap on interest earnings. However, remember that interest is taxable income, so higher earnings mean higher taxes owed.

What is the difference between APY and APR?

APY (annual percentage yield) is the interest rate you actually earn when compounding is included. APR (annual percentage rate) is the interest rate before compounding is factored in. Banks must show you the APY on savings accounts, which is the number that matters for comparing accounts. APR is used more often for loans.