Banks pay interest by crediting a percentage of your account balance back to you on a set schedule
Interest is money the bank pays you for letting them use your deposits. The bank lends out most of what you deposit to other customers as mortgages, car loans, and business loans. In return, they share a portion of what they earn with you. The amount you receive depends on three things: how much money sits in your account, the interest rate the bank offers, and how often the bank compounds (adds) the interest.
The bank decides the interest rate, and it changes based on what the Federal Reserve does with its benchmark rate. When the Fed raises rates, banks typically raise savings rates within weeks or months. When the Fed cuts rates, savings rates fall. This is why the interest you earn today might be different from what you earned last year or will earn next year.
Key Takeaways
- Interest rates on savings accounts are set by individual banks and move up or down based on Federal Reserve policy changes.
- The interest you earn depends on your balance, the annual percentage yield (APY), and how often the bank compounds interest—usually daily or monthly.
- Online banks typically offer higher rates than brick-and-mortar banks because they have lower overhead costs.
- Interest is taxable income, and you will receive a 1099-INT form from your bank if you earn $10 or more in a calendar year.
Understanding annual percentage yield (APY) and how it compounds
APY is the rate the bank advertises, and it already includes the effect of compounding. Compounding means the bank adds interest to your account, and then pays interest on that interest in the next period. If a bank compounds daily, you earn interest on your balance every single day, and each day's interest gets added before the next day's calculation. If it compounds monthly, the same thing happens once a month.
A bank that compounds daily will pay you slightly more than one that compounds monthly, even if both advertise the same APY—because you earn interest on interest more often. Most savings accounts compound daily, which is why you should look for that detail when comparing banks. The difference is small on small balances but adds up on larger ones.
For example, if you have $10,000 in an account earning 4.50% APY compounded daily, you will earn roughly $450 over a year. If the same account compounded monthly instead, you would earn slightly less—but the APY already reflects this, so the advertised rate accounts for the compounding frequency.
How often banks credit interest to your account
Banks credit interest to your account on different schedules. Some credit monthly, some quarterly, and some daily. The frequency of crediting does not change how much you earn—the APY already accounts for it—but it does affect when you see the money appear in your account.
Most online banks credit interest monthly on the last day of the month or the first day of the next month. Some credit quarterly. A few credit daily, meaning interest shows up in your balance every single day, though you may not see a separate line item for it. Check your bank's account terms or call customer service to find out the exact schedule for your account.
Why online banks pay higher interest than traditional banks
Online banks typically offer rates 4 to 10 times higher than brick-and-mortar banks. This is not because they are more generous—it is because they have far lower costs. An online bank does not maintain physical branches, pay tellers, or lease office space. They pass those savings to customers by offering higher rates to attract deposits.
A traditional bank with branches in your town might offer 0.01% APY on a savings account. An online bank might offer 4.50% APY on the same type of account. Both are real banks with FDIC insurance. The difference is overhead. If you keep your savings at a brick-and-mortar bank primarily for in-person service, understand that you are paying for that convenience in the form of much lower interest.
What happens to interest rates when the Federal Reserve makes changes
The Federal Reserve does not set savings account rates directly. Instead, it sets the federal funds rate, which is the rate banks charge each other for overnight loans. When the Fed raises this rate, banks have less incentive to borrow from each other, so they compete harder for deposits by raising savings rates. When the Fed cuts rates, banks need fewer deposits and lower their rates.
The lag between a Fed move and a rate change at your bank is usually two to four weeks for online banks, which move quickly to stay competitive. Traditional banks may take longer. If you are shopping for a savings account and the Fed has recently cut rates, expect the rates you see today to be higher than what banks will offer in a month or two. If the Fed is raising rates, the opposite is true—rates will likely climb.
Interest is taxable income you must report
Interest you earn on a savings account is taxable income. You must report it on your federal tax return. 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 use this form to report the interest on your tax return.
If you earn less than $10, the bank does not have to send a 1099-INT, but you still owe tax on the interest. Keep your own records of interest earned if your balance is small. The interest is taxed at your ordinary income tax rate, not at a special rate. This means if you are in the 22% tax bracket, you will owe roughly 22% of your interest earnings in federal tax (plus any state income tax, depending on where you live).
How to find the best interest rate for your situation
Compare APY across banks, not just the headline rate. Make sure the rate you are looking at is the current rate, not a promotional rate that expires after a few months. Read the fine print to see if there are minimum balance requirements or if the rate drops if your balance falls below a certain amount.
Check whether the bank compounds daily and how often it credits interest. Look at the bank's FDIC insurance coverage—most banks insure up to $250,000 per depositor per account type, but some offer higher coverage through special structures. Consider whether you need online access, mobile banking, or the ability to withdraw cash at a physical location. The highest rate means nothing if the bank does not offer the features you need.
Frequently Asked Questions
Do I have to do anything to earn interest on my savings account?
No. Once you open the account and deposit money, the bank automatically calculates and credits interest according to the schedule in your account agreement. You do not need to take any action. Interest accrues whether you check your account or not.
Can I lose money if interest rates fall?
No. A falling interest rate means you will earn less interest going forward, but you will not lose the principal you deposited or the interest you have already earned. Your balance only goes up, never down, unless you withdraw money yourself.
What is the difference between APY and APR?
APY (annual percentage yield) includes the effect of compounding and is used for savings accounts. APR (annual percentage rate) does not include compounding and is used for loans and credit cards. Always compare APY to APY when shopping for savings accounts.
If I move my money to a different bank, do I lose the interest I earned?
No. Interest you have already earned stays in your account and transfers with you. The new bank will credit interest going forward at its own rate. You only lose future interest if the new bank offers a lower rate.
How much interest will I earn on my specific balance?
Multiply your balance by the APY and divide by 12 for a rough monthly estimate. For example, $5,000 at 4.50% APY earns roughly $18.75 per month. Use your bank's interest calculator on their website for a precise figure, since compounding and crediting schedules vary.