Banks pay interest by calculating a percentage of your balance and depositing that amount into your account on a schedule they set

The bank takes money you deposit, lends it out to other customers as mortgages and loans, and keeps the difference between what it pays you and what borrowers pay it. That difference is how the bank makes money. The interest rate on your savings account is what the bank offers to rent your money for a set period. The rate varies by bank, by account type, and by how much you have deposited.

Interest is calculated using your account balance on specific days. Most banks use one of two methods: daily balance or average daily balance. With daily balance, the bank calculates interest on your exact balance each day, then adds those daily amounts together at the end of the month. With average daily balance, the bank adds up your balance for each day of the month and divides by the number of days to get an average, then calculates interest on that average. The second method usually results in slightly higher interest if your balance fluctuates.

The actual deposit into your account happens on a posting schedule that the bank controls. Most banks post interest monthly, though some post quarterly or annually. A few online banks post daily. You will see the deposit listed as "interest paid" or "interest earned" in your transaction history. Once the interest is posted, it becomes part of your balance and earns interest itself the next period—this is called compounding.

Key Takeaways

  • Banks calculate interest using either your daily balance or your average daily balance over the month, then multiply by the annual interest rate and divide by 12 for a monthly payment.
  • Interest posts to your account on a schedule the bank sets—usually monthly, sometimes quarterly or daily—and becomes part of your balance when ready.
  • The interest rate you receive depends on the bank, the account type, and current market conditions; rates change and are not may provide to stay the same.
  • Compounding means the interest you earn starts earning interest itself, which is why accounts that post interest more frequently build slightly faster.
  • You pay no tax on interest until you receive it, and the bank will send you a 1099-INT form at the end of the year if you earned $10 or more.

How the interest rate is set and what makes it change

Banks set their own interest rates based on what the Federal Reserve does with its benchmark rate, called the federal funds rate. When the Fed raises its rate, banks typically raise the rates they offer on savings accounts. When the Fed lowers its rate, banks usually lower savings rates too. However, banks do not move at the same speed or by the same amount. A bank might wait weeks or months to raise a savings rate after the Fed moves, or it might raise by less than the Fed did.

The type of account also matters. A high-yield savings account at an online bank usually offers a higher rate than a regular savings account at a brick-and-mortar bank, because online banks have lower overhead costs. A money market account may offer a rate between the two. A certificate of deposit (CD) locks your money away for a set term—three months, one year, five years—and in exchange offers a higher rate than a savings account. The longer the term, the higher the rate is usually offered, because the bank gets to use your money for longer.

Interest rates are not may provide. The bank can lower the rate on your account at any time, though most banks give you notice before they do. If you have a CD, the rate is locked in for the term you chose, so it will not change until the CD matures. When it matures, you can renew it at whatever rate the bank is offering then, or move your money elsewhere.

The math behind the interest calculation

The formula banks use is straightforward: Balance × Annual Interest Rate ÷ 12 = Monthly Interest. If you have $10,000 in an account earning 4.5% annual interest, the calculation is $10,000 × 0.045 ÷ 12 = $37.50 per month. That $37.50 posts to your account, and next month your balance is $10,037.50, which earns slightly more interest because the balance is higher.

With daily balance calculation, the bank does this math for each day of the month using that day's balance, then adds all the daily interest amounts together. If your balance changes during the month—you deposit $5,000 or withdraw $2,000—the daily balance method captures that change when ready. The average daily balance method smooths out those changes by averaging them across the month, which can result in a slightly different total depending on when deposits and withdrawals happen.

The difference between the two methods is usually small—a few cents or dollars per month on typical balances. But if you move large sums in and out of the account, the method matters more. You can find which method your bank uses in the account disclosure document, which the bank must provide before you open the account.

Why compounding makes a real difference over time

Compounding is the reason interest-earning accounts build faster the longer you leave money untouched. When the bank posts interest to your account, that interest becomes part of your balance. The next month, you earn interest on the original balance plus the interest from the previous month. The month after that, you earn interest on all three amounts.

The effect is small in the short term but meaningful over years. On $10,000 at 4.5% annual interest posted monthly, you earn $37.50 the first month. The second month, you earn interest on $10,037.50, which is $37.64. By the end of a year, you have earned $461.36 instead of the $450 you would earn if interest did not compound. After five years, the difference grows to $2,460 versus $2,250—a gain of $210 from compounding alone.

The frequency of posting matters. If a bank posts interest daily instead of monthly, you earn interest on your interest more often, which compounds faster. If a bank posts quarterly, you earn interest on your interest less often, which compounds slower. This is why comparing banks on the annual percentage yield (APY) rather than the annual percentage rate (APR) is important—APY includes the effect of compounding, while APR does not.

What happens to interest in your tax situation

Interest you earn on a savings account is taxable income. You do not pay tax when the interest posts to your account; you pay tax on it when you file your tax return for the year you earned it. The bank reports the interest to the IRS on a form called a 1099-INT, which the bank sends to you by January 31 of the following year. You only receive a 1099-INT if you earned $10 or more in interest during the year.

The interest is taxed at your ordinary income tax rate, which depends on your total income and tax bracket. If you earned $500 in interest and you are in the 22% tax bracket, you owe $110 in federal tax on that interest (though state and local taxes may explore too). This is why the real return on a savings account is lower than the stated interest rate—you keep only the after-tax portion.

If you have multiple savings accounts at different banks, each bank reports its interest separately on its own 1099-INT. You add all the interest together on your tax return. If you earned less than $10 at a particular bank, that bank does not send a 1099-INT, but you still owe tax on that interest if your total interest for the year exceeds $10.

How to compare interest rates between banks

The most useful number to compare is the annual percentage yield (APY), not the annual percentage rate (APR). APY includes the effect of compounding, so it tells you the real return you will get. Two banks might offer the same APR, but if one compounds daily and the other compounds monthly, the one that compounds daily will give you a slightly higher APY.

You can find current rates on bank websites, on financial comparison sites, and on the Federal Deposit Insurance Corporation (FDIC) website, which lists rates from thousands of banks. When you compare, look at the APY, the posting frequency, and any minimum balance requirements. Some banks offer a higher rate only if you maintain a certain balance; if your balance drops below that, the rate drops too.

Also check whether the rate is promotional or permanent. Some banks offer a high rate for a limited time to attract new customers, then lower it after a few months. The bank should disclose this in the account terms, but it is worth asking before you open the account. A rate that is may provide for a year is more useful to compare than a promotional rate that expires in three months.

When interest stops accruing and what happens to dormant accounts

Interest accrues as long as your account is open and active. If you stop using the account but leave money in it, the bank continues to pay interest on the balance. However, if an account shows no activity—no deposits, withdrawals, or interest posts—for a very long time, the bank may classify it as dormant or abandoned. The rules vary by state, but typically this happens after three to five years of no activity.

When an account is classified as abandoned, the bank must turn the money over to the state's unclaimed property program. You do not lose the money, but you have to file a claim with the state to get it back. The process can take weeks or months. To avoid this, make at least one transaction per year—a small deposit or withdrawal—or check your account online periodically to show activity.

If you close the account, the bank stops paying interest on that balance when ready. Any interest that has already posted to the account is yours to keep. If you close the account before interest posts for the month, you lose the interest for that partial month—the bank does not pay interest on closed accounts.

Frequently Asked Questions

Can I lose money if the bank lowers the interest rate?

No. Lowering the interest rate means you earn less interest going forward, but the money you already have stays in the account. If you had $10,000 earning 4.5% and the bank lowers the rate to 3%, you still have $10,000—you just earn less interest each month from that point on. You can move your money to another bank if you want a higher rate.

What is the difference between APR and APY?

APR is the annual percentage rate without compounding. APY is the annual percentage yield and includes the effect of compounding. If a bank offers 4.5% APR compounded monthly, the APY will be slightly higher—around 4.59%—because you earn interest on your interest. Always compare banks using APY, not APR.

Do I have to report interest under $10 on my taxes?

The bank does not send you a 1099-INT if you earned less than $10, but you still owe tax on that interest if your total interest income for the year exceeds $10. You report all interest earned, even if you did not receive a 1099-INT for some of it. Keep your own records of interest from all accounts.

Why do online banks pay higher interest than traditional banks?

Online banks have lower overhead costs because they do not operate physical branches. They pass some of those savings to customers in the form of higher interest rates. Traditional banks have to maintain buildings, staff, and equipment, which costs more money. Both types of accounts are insured by the FDIC up to $250,000, so the safety is the same.

Does interest compound if I withdraw money before it posts?

If you withdraw money before the interest posts for the month, you lose the interest for that period. The bank calculates interest based on your balance on the posting date. If you withdraw the money before that date, the balance is lower, so the interest is lower or zero. Once interest posts to your account, it is yours even if you withdraw it later.