Banks pay interest by calculating a percentage of your account balance and crediting that amount to your account on a set schedule—usually monthly or daily, depending on the bank and account type.
The interest rate itself is set by the bank, not by you. It changes based on what the Federal Reserve does with its benchmark rate, which it adjusts several times a year. When the Fed raises rates, banks typically raise savings rates within weeks or months. When the Fed cuts rates, savings rates fall. Your bank decides how much of that change to pass along to you—some banks move quickly, others lag behind.
The actual dollar amount you earn depends on three things: your balance, the interest rate your bank offers, and how often the bank compounds the interest (meaning how often it calculates interest on your interest). A bank that compounds daily will pay you slightly more than one that compounds monthly, even at the same stated rate.
Key Takeaways
- Banks calculate interest as a percentage of your balance and pay it on a schedule—usually monthly, daily, or quarterly—depending on the account and institution.
- The interest rate your bank offers moves with the Federal Reserve's benchmark rate, but your bank chooses how quickly to raise or lower your rate.
- Compounding frequency matters: daily compounding pays slightly more than monthly compounding at the same rate, because interest earns interest.
- You can compare rates across banks using the Annual Percentage Yield (APY), which accounts for compounding and shows the true yearly return.
How the Federal Reserve sets the floor for what banks pay
The Federal Reserve does not set savings account rates directly. Instead, it sets the federal funds rate—the interest rate banks charge each other for overnight loans. This rate influences what banks pay on savings accounts, but the connection is loose and delayed.
When the Fed raises its benchmark rate, banks have more incentive to offer higher savings rates because they can earn more on the money they lend out. When the Fed cuts rates, banks lower savings rates because their own earnings shrink. The timing varies: some banks move within days, others wait weeks or months. Online banks tend to move faster than brick-and-mortar banks because they have lower overhead and compete more directly on rate.
Your bank's rate is also influenced by how much competition exists in your area and how much the bank needs deposits. A bank flush with customer deposits may not raise rates even when the Fed does. A bank that needs more money in the door will raise rates faster than its competitors.
The difference between stated rate and APY
Banks advertise two numbers: the interest rate (also called the annual percentage rate, or APR) and the Annual Percentage Yield, or APY. The APY is the number that matters for comparing accounts, because it includes the effect of compounding.
Here is the difference in practice. Suppose a bank offers 4.50% APR compounded daily on a savings account. That 4.50% is the base rate. But because interest is calculated and added to your balance every day, you earn interest on that interest. By the end of the year, your actual return is slightly higher—the APY might be 4.60%. The difference grows with larger balances and higher rates.
When you are comparing two savings accounts, always use the APY, not the stated rate. The APY tells you the true yearly return. A bank advertising 4.50% APY with daily compounding will pay you more than a bank advertising 4.50% APR with monthly compounding.
How often banks calculate and credit interest
Banks calculate interest on different schedules depending on the account type and the bank's systems. The most common schedules are daily, monthly, and quarterly.
Daily compounding means the bank calculates interest on your balance every day and adds it to your account. That new balance then earns interest the next day. This is the most common method for high-yield savings accounts and money market accounts. Daily compounding produces the highest return because your interest earns interest more frequently.
Monthly compounding means interest is calculated once a month and credited to your account. This is common in traditional savings accounts at brick-and-mortar banks. Quarterly compounding happens four times a year. Both pay less than daily compounding at the same stated rate, because your interest sits idle longer before it starts earning interest itself.
The bank's disclosure documents—usually called the Truth in Savings Act disclosure or the account agreement—will state the compounding frequency. You can request this document before opening an account, or find it on the bank's website.
What happens to your interest if you withdraw money mid-month
Most savings accounts calculate interest based on your balance at the end of each compounding period. If you withdraw money partway through the month, the bank calculates interest on the lower balance for that period.
Some banks use the average daily balance method instead: they add up your balance for each day of the month and divide by the number of days. This method is less common in savings accounts but more common in money market accounts. It slightly smooths out the impact of withdrawals, but you still earn less interest in months when you withdraw.
A few banks use the low balance method, where interest is calculated on the lowest balance you held during the period. This is rare and unfavorable to the customer. Check your account agreement to see which method your bank uses.
Why some banks pay more interest than others
Two banks might offer the same interest rate, but one will pay you more over time because of compounding frequency or because it credits interest more often. But the bigger difference comes from the rate itself: a bank offering 4.75% APY will pay you significantly more than a bank offering 3.50% APY, even if both compound daily.
Online banks and credit unions typically offer higher rates than traditional banks because they have lower operating costs and less branch overhead. They pass some of that savings to customers in the form of higher rates. Traditional banks often offer lower rates because they maintain physical locations and have higher staff costs.
Banks also adjust rates based on how much they need deposits. During periods when the Fed is raising rates, banks compete aggressively for deposits and raise their rates quickly. During periods when the Fed is cutting rates, banks lower rates more slowly because they do not need to attract as many deposits.
How to track your interest earnings and verify the calculation
Your bank sends you a statement—usually monthly, sometimes quarterly—that shows how much interest you earned that period. The statement will list the interest rate, the compounding method, and the dollar amount credited to your account.
You can verify the calculation yourself using the formula: Interest = Principal × Rate × Time. For daily compounding, the math is more complex because the principal changes every day, but your statement should show the total. If the amount seems wrong, contact your bank and ask them to explain the calculation. Banks make errors occasionally, and they are required to correct them.
You can also use an online savings calculator to estimate what you should earn. Enter your balance, the APY, and the compounding frequency, and the calculator will show you the projected interest. If your actual earnings are significantly lower, ask your bank why.
Frequently Asked Questions
Does interest compound on interest in a savings account?
Yes, if your bank compounds interest daily or monthly. The interest earned in one period is added to your balance, and the next period's interest is calculated on that larger balance. This is called compounding. The more frequently interest compounds, the more you earn. Daily compounding produces the highest return.
What happens to my interest if I close the account before the end of the month?
You receive the interest earned up to the day you close the account. Banks calculate interest daily or monthly depending on the account, so you are not penalized for closing early. Some banks may require you to maintain a minimum balance to earn the stated rate, so check your account agreement.
Can a bank lower my interest rate without notice?
Yes. Banks can change savings rates at any time without advance notice, though many send an email or letter. The rate you see when you open an account is not may provide to stay the same. If your bank lowers its rate and you want a higher return, you can move your money to another bank.
Is the interest I earn on a savings account taxable?
Yes. Interest earned on a savings account is considered income and is taxable by the IRS. Your bank will send you a Form 1099-INT at the end of the year if you earned $10 or more in interest. You report this on your tax return. State income tax may also explore depending on where you live.
Why is my APY lower than the rate advertised on the bank's website?
Banks sometimes lower rates after you open an account. Check your most recent statement to see the current rate on your account. If it is lower than what the bank advertises to new customers, your rate may have been reduced. You can contact the bank to ask when the change happened and whether you can move to a higher-rate account.