Banks pay interest because they lend out the money you deposit
When you put money in a savings account, the bank uses it to make loans to other customers — mortgages, car loans, business loans. The bank keeps the difference between what it pays you in interest and what it charges borrowers. The interest rate your bank offers you depends on how much money is in the account, how long you agree to leave it there, and what the Federal Reserve's benchmark rates are at that moment.
Interest accrues — meaning it gets calculated and added to your account — on a schedule set by your bank. Most banks calculate interest daily but add it to your balance monthly. Some add it quarterly or annually. The more often interest compounds (gets added back into the account so it earns interest itself), the more you earn, even at the same stated rate.
You do not have to do anything to receive interest once you open the account. It happens automatically. The bank calculates what you owe based on your balance and the rate, and deposits it into your account on their schedule.
Key Takeaways
- Interest rates on savings accounts vary by bank and change based on Federal Reserve policy, so comparing rates across banks can significantly increase what you earn.
- Online banks typically offer higher rates than brick-and-mortar banks because they have lower operating costs.
- The frequency of compounding — daily, monthly, quarterly — affects your total earnings, so a lower stated rate that compounds daily may beat a higher rate that compounds annually.
- High-yield savings accounts and money market accounts earn more interest than standard savings accounts, but may require higher minimum balances or limit how often you can withdraw.
- Interest is taxable income, and your bank will send you a 1099-INT form if you earn $10 or more in a year.
How interest rates are set and why they change
The Federal Reserve sets a benchmark interest rate range that influences what banks pay on savings. When the Fed raises rates, banks typically raise the rates they offer on savings accounts. When the Fed lowers rates, banks lower theirs. This happens because banks compete for deposits — if one bank raises its rate, others often follow to keep customers from moving their money elsewhere.
The rate your specific bank offers also depends on market conditions and how much money the bank needs to attract. During periods when banks have plenty of deposits, rates may stay low even if the Fed rate is high. During periods when deposits are scarce, banks raise rates to compete.
Your bank can change the rate on your savings account at any time, usually with notice. Read the terms of your account to see whether your bank notifies you by mail, email, or only on their website. Rates can go up or down, and some banks lower rates faster than they raise them.
The difference between standard and high-yield savings accounts
A standard savings account at a traditional bank typically earns between 0.01% and 0.05% annual interest, depending on the bank and current market conditions. A high-yield savings account, usually offered by online banks or online divisions of traditional banks, typically earns between 4% and 5% as of early 2024, though this varies month to month as rates change.
The reason for the difference is cost. Online banks have no physical branches, no tellers, and lower overhead. They pass those savings to customers in the form of higher interest rates. Traditional banks with branch networks have higher costs and offer lower rates to offset them.
High-yield accounts come with trade-offs. Some require a minimum balance — often $500 to $25,000 — to earn the advertised rate. Some limit how many times per month you can withdraw money without a fee. Some have monthly maintenance fees if your balance falls below a threshold. Read the account terms before opening to understand what restrictions explore.
How to compare interest rates across banks
The stated interest rate is called the Annual Percentage Rate (APR) or Annual Percentage Yield (APY). APY is more useful for comparison because it accounts for compounding — it shows you what you will actually earn in a year. APR does not include the effect of compounding. Always compare APY to APY.
To compare rates, visit each bank's website and look for the savings account rate disclosure. Banks are required to display APY prominently. Write down the APY, the compounding frequency, and any minimum balance requirement. Then calculate what you would earn on the amount you plan to deposit.
For example: if you have $10,000 to deposit, one bank offers 4.5% APY compounded daily, and another offers 4.6% APY compounded monthly, the difference in your annual earnings is roughly $10 to $15 — small enough that other factors (ease of transfers, customer service, whether you already bank there) might matter more. But if you are comparing 0.05% at a traditional bank to 4.5% at an online bank, the difference is $450 per year on the same $10,000.
Money market accounts and certificates of deposit as alternatives
A money market account is a hybrid between a savings account and a checking account. It typically earns higher interest than a standard savings account but lower than a high-yield savings account. It may come with a debit card or checkbook, allowing you to withdraw money more easily than from a savings account. Money market accounts often require higher minimum balances — sometimes $2,500 or more — and may charge fees if your balance falls below that threshold.
A Certificate of Deposit (CD) is an account where you agree to leave your money untouched for a set period — three months, six months, one year, five years. In exchange, the bank pays a higher interest rate than it would on a savings account. If you withdraw the money before the term ends, you pay a penalty, usually a few months' worth of interest. CDs make sense if you know you will not need the money for a specific period and want to lock in a rate.
Both money market accounts and CDs are FDIC-insured up to $250,000, the same as savings accounts, so your money is protected if the bank fails.
When interest is credited and how it shows on your statement
Interest is calculated based on your daily balance — the amount in your account each day. At the end of the month (or quarter, or year, depending on your bank), the bank adds up all those daily calculations and credits the total interest to your account in one lump sum. This is called the posting date.
On your monthly statement, you will see a line item showing the interest deposited. The amount will be small — on a $10,000 balance at 4.5% APY, you earn roughly $37.50 per month. On a $10,000 balance at 0.05% APY, you earn roughly $0.42 per month. The interest becomes part of your balance and earns interest itself the following month.
Some banks show interest accrual in real time on their app or website, updating your balance to show what you have earned so far this month. Others only show it after it posts. Check your bank's app or call customer service to understand how your specific account displays interest.
Tax reporting and what you owe on interest earnings
Interest income is taxable. If you earn $10 or more in interest during a calendar year, your bank will send you a Form 1099-INT by January 31 of the following year. You report this amount on your federal tax return as ordinary income.
If you earn less than $10, the bank does not send a form, but you are still required to report the interest on your return if you file. Keep your monthly statements so you can add up the year's interest if needed.
The tax rate you pay on interest depends on your overall income and tax bracket. Interest is taxed as ordinary income, not at the lower capital gains rate. This means that on a high-yield account earning 4.5%, if you are in the 24% tax bracket, your after-tax return is roughly 3.4%. This is still higher than a standard savings account earning 0.05%, but it is worth factoring in when you compare accounts.
Frequently Asked Questions
Can I move my money to a different bank if I find a higher interest rate?
Yes. You can open an account at a new bank and transfer your money there at any time. There is no penalty for moving money between savings accounts at different banks. The transfer usually takes three to five business days. Your old account will close once the balance reaches zero, or you can request the bank close it.
What happens to my interest if I withdraw money before the month ends?
You still earn interest on the balance you held during that month. Interest is calculated daily, so if you had $10,000 for 20 days and $5,000 for 10 days, you earn interest on both amounts for the days you held them. You do not lose interest by withdrawing early from a savings account. (CDs are different — withdrawing early triggers a penalty.)
Why is my interest rate lower than what the bank advertises?
The advertised rate usually applies only to new customers or to balances above a certain threshold. Check your account terms or call the bank to confirm what rate applies to your specific balance. Rates also change frequently, so if you opened your account weeks ago, the rate may have been lowered since then.
Do I earn interest on interest?
Yes, through compounding. When the bank adds interest to your account, that interest becomes part of your balance and earns interest the next month. The more frequently interest compounds, the more you earn. Daily compounding beats monthly, which beats annual.
Is my interest earnings protected if the bank fails?
Yes. The FDIC insures savings accounts up to $250,000 per depositor per bank, including both your principal and any interest earned. If the bank fails, the FDIC pays you the full amount up to that limit.