How your bank decides what interest you earn
Banks calculate savings account interest using one of two methods: straightforward interest or compound interest. Most savings accounts use compound interest, which means you earn interest not just on your original deposit, but also on the interest that has already accumulated. This is the faster way your money grows.
The actual dollar amount you earn depends on three things: how much money is in your account, what interest rate the bank is offering, and how often the bank compounds—that is, how often it adds the interest back into your account so you start earning interest on that interest too.
Banks are required to disclose their interest rate and compounding frequency before you open an account. You will see this information in the account disclosure document, often called a Truth in Savings disclosure or account agreement. The rate itself can change at any time on variable-rate accounts, though the bank must notify you of changes.
Key Takeaways
- Compound interest means you earn interest on your interest, and most savings accounts use this method rather than straightforward interest.
- Your earnings depend on the account balance, the annual interest rate (called APY), and how often the bank compounds the interest.
- Banks must tell you the APY and compounding frequency in writing before you open the account, and this information is also shown on your monthly or quarterly statement.
- The more frequently a bank compounds interest—daily is better than monthly—the more you earn, even at the same stated rate.
- Interest rates on savings accounts change regularly and vary widely between banks, so comparing rates before opening an account can significantly affect your earnings.
The difference between APY and the interest rate
Banks advertise two numbers: the interest rate and the APY (annual percentage yield). These are not the same thing, and understanding the difference matters for comparing accounts.
The interest rate is the percentage the bank pays on your balance. The APY is what you actually earn when you factor in how often the bank compounds. For example, a bank might offer 4.50% interest compounded daily. When you compound daily instead of annually, your actual earnings are slightly higher—the APY might be 4.60%. Banks are required to show you the APY prominently, because it reflects what you will actually receive.
When you are comparing savings accounts at different banks, always compare the APY, not the interest rate. Two banks offering the same interest rate can have different APYs if they compound at different frequencies.
How compounding frequency affects what you earn
Compounding frequency is how often the bank adds earned interest back into your account. The options are daily, monthly, quarterly, or annually. The more frequently interest compounds, the more you earn.
Here is why: when interest compounds daily, the bank adds your earned interest to your balance every day. The next day, you earn interest on that larger balance. When interest compounds only monthly, you wait 30 days before that interest is added, so you miss out on earning interest on your interest for that whole month.
The difference is small on small balances but becomes noticeable as your account grows. A $10,000 balance at 4.50% APY compounded daily will earn more over a year than the same balance at 4.50% APY compounded monthly, even though the stated rate is identical. This is why the APY—which includes the effect of compounding—is the number to watch.
What happens to interest if you withdraw money mid-month
Most banks calculate interest based on your balance at the end of each compounding period. If you withdraw money partway through the month, the interest you earn that month is based on the lower balance from the end of the period, not your starting balance.
Some accounts use the average daily balance method instead. This means the bank adds up your balance at the end of each day during the month, divides by the number of days, and calculates interest on that average. With this method, a withdrawal partway through the month reduces your interest proportionally rather than wiping out the month's earnings entirely.
Your account disclosure will state which method your bank uses. If you make frequent withdrawals, an account using average daily balance may earn you slightly more interest than one using the ending balance method.
When interest is actually added to your account
Interest compounds on a schedule set by the bank—usually daily or monthly—but you may not see it posted to your account on the same day it is calculated. Banks typically post interest once a month, often on the last day of the month or the first day of the next month.
Even if interest compounds daily, you will usually see it appear in your account only once monthly. This does not change how much you earn; the compounding still happens daily in the bank's calculation. The posting date is just when the money actually shows up in your balance.
You can see the interest earned in the current period on your monthly or quarterly statement. The statement will show the interest posted, the rate it was calculated at, and sometimes the average balance used for the calculation.
How interest rates change and what triggers a change
Banks set their own savings account rates and can change them at any time. Rates typically move in response to changes in the Federal Reserve's benchmark interest rate, but banks do not have to match those changes when ready or completely.
When the Federal Reserve raises its rate, banks usually raise savings account rates within days or weeks. When the Federal Reserve lowers its rate, banks often lower savings account rates much faster than they raised them. This is because banks compete more aggressively for deposits when rates are rising, but have less incentive to do so when rates are falling.
Your bank must notify you in writing before lowering your interest rate, though the timing and notice period vary by state and bank. You will usually receive notice by email or mail at least 21 days before the change takes effect. If you disagree with a rate cut, you can withdraw your money without penalty during the notice period, though you will not earn interest on the withdrawn amount after the notice date.
Why the same balance earns different amounts at different banks
Two people with identical $5,000 balances in savings accounts will earn different amounts of interest if their banks offer different APYs. This is the main reason to compare rates before opening an account.
Interest rate differences may seem small—the difference between 4.25% APY and 4.75% APY is only half a percentage point—but over a year, that 0.50% difference means $25 in additional earnings on a $5,000 balance. On larger balances or longer time periods, the difference grows quickly.
Online banks typically offer higher APYs than brick-and-mortar banks because they have lower overhead costs. Credit unions sometimes offer competitive rates as well. Your current bank may not be offering the best rate available, so checking other institutions before depositing a large sum is worth the time.
Frequently Asked Questions
Does interest compound on money I just deposited?
Yes, but only starting from the day the deposit clears and is available in your account. If you deposit money on a Friday and it does not clear until Monday, interest begins accruing on Monday. The bank's disclosure will state how long deposits take to clear.
What if my bank offers 5% interest but the APY is 5.12%?
The 5% is the stated rate and 5.12% is the APY. The APY is higher because of daily compounding—you are earning interest on your interest. Always use the APY when comparing accounts, because it shows what you will actually receive.
Can a bank lower my interest rate without warning?
Banks must notify you in writing before lowering your rate, usually at least 21 days in advance. You can withdraw your money during the notice period without penalty. The exact notice requirement depends on your state and the bank's account agreement.
Is interest taxable?
Yes. Banks report interest earned to the IRS on a Form 1099-INT if you earn $10 or more in a calendar year. You must report this interest as income on your tax return. The bank will send you the form by January 31 of the following year.
Why do some accounts compound daily but post interest monthly?
Daily compounding means the bank calculates and adds interest to your balance every day for earning purposes. Monthly posting means you see that accumulated interest appear in your account once a month. Both happen; you just see the result less frequently than it is calculated.