Interest is money the bank pays you for keeping your money with them

When you put money in a savings account, the bank uses that money to lend to other customers. Because the bank is using your money to make money, they pay you a share of what they earn. That payment is called interest. The bank tells you the interest rate — a percentage — and calculates how much to pay you based on how much money you have in the account and how long it stays there.

The amount of interest you earn depends on three things: how much money is in your account, what interest rate the bank offers, and how often the bank calculates and adds the interest to your balance. A higher interest rate means you earn more. A larger balance means you earn more. And interest that is calculated more frequently — daily instead of monthly, for example — means you earn slightly more because the bank adds interest to interest.

Interest rates on savings accounts are very low right now compared to other ways to save money, but they are still better than keeping cash at home, where you earn nothing. The rate your bank offers can change at any time, and different banks offer different rates, so it is worth comparing before you open an account.

Key Takeaways

  • Banks pay you interest because they use your deposits to lend money to other customers and earn a profit.
  • Your interest earnings depend on your account balance, the interest rate the bank offers, and how often interest is calculated and added to your account.
  • Interest rates vary between banks and can change, so comparing rates before opening an account can mean earning more money over time.
  • Interest that is calculated daily and added to your balance grows slightly faster than interest calculated monthly, because you earn interest on the interest already added.
  • Even a small interest rate is better than keeping money in cash at home, where you earn nothing.

How the bank calculates the interest you earn

The bank uses a formula based on your balance, the interest rate, and the time period. If your account earns 4.5% annual interest and you have $1,000 in the account for a full year, you would earn $45 in interest (1,000 × 0.045 = 45). But most banks do not wait a full year to pay you. Instead, they calculate interest daily and add it to your account monthly, weekly, or even daily.

When interest is added to your account, it becomes part of your new balance. The next time the bank calculates interest, it calculates on the larger amount — the original money plus the interest already paid. This is called compound interest, and it means your money grows a little faster than straightforward math would suggest. The more often interest is compounded, the more you earn, though the difference is usually small on savings accounts.

You can find the interest rate your bank offers in the account disclosure document they give you when you open the account, or on their website. The document will also tell you how often interest is compounded — daily, monthly, or quarterly. Some banks show you an APY (Annual Percentage Yield) instead of just the interest rate. APY already includes the effect of compounding, so it is the actual amount you will earn in a year.

Why interest rates are different at different banks

Banks set their own interest rates based on what the Federal Reserve does and what other banks are offering. When the Federal Reserve raises its rates, banks usually raise the interest they pay on savings accounts. When the Federal Reserve lowers its rates, banks usually lower what they pay you. This is why the interest rate you see today might be different from the rate you saw six months ago.

Online banks — banks that have no physical branches and operate only on the internet — usually offer higher interest rates than traditional banks with branches in your neighborhood. This is because online banks have lower costs to run, so they can afford to pay you more. If you are willing to manage your account through a website or app instead of visiting a branch, an online bank can mean earning significantly more interest on the same balance.

What happens to your interest if you withdraw money early

If you withdraw money from your savings account before the interest is calculated and added, you lose the interest on the amount you withdrew. For example, if you have $1,000 earning interest and you withdraw $300 before the monthly interest is added, the bank calculates interest only on the $700 that remained in the account. You do not earn interest on the $300 you took out.

Some savings accounts have withdrawal limits — rules about how many times per month you can take money out. If you exceed the limit, the bank may charge you a fee or move your account to a different type of account. Before you open a savings account, check whether it has withdrawal limits and what they are. If you think you will need to access your money frequently, a checking account might be a better choice, even though it usually earns little or no interest.

The difference between savings accounts and other ways to earn interest

Savings accounts are not the only way to earn interest on money you are not spending right now. Money market accounts often pay slightly higher interest than savings accounts but require a larger opening deposit and may have withdrawal limits. Certificates of deposit (CDs) pay higher interest if you agree to leave your money in the account for a set period — three months, one year, five years — and not touch it. If you withdraw from a CD before the time is up, you pay a penalty.

High-yield savings accounts are savings accounts that pay much higher interest than regular savings accounts. They are offered by online banks and some traditional banks. The catch is that you usually cannot earn this higher rate on very small balances — many require $2,500 or more to open. If you have a larger amount to save and do not need to access it frequently, a high-yield savings account or a CD might earn you significantly more interest than a regular savings account.

How to compare interest rates before opening an account

Before you open a savings account, visit the websites of at least three banks and write down the interest rate and APY each one offers. Check whether the rate applies to all balances or only balances above a certain amount. Some banks offer a higher rate on the first $10,000 and a lower rate on anything above that. Look at the account disclosure document — usually called a "Truth in Savings" document — to see how often interest is compounded and whether there are withdrawal limits or monthly fees.

Keep in mind that interest rates change. The rate you see today might be higher or lower in three months. If you find a bank offering a rate that is much higher than others, that rate might not last. But comparing rates before you open an account means you start with the best option available at that moment. After you open an account, you can check your bank's rate periodically and consider moving your money to a different bank if rates have risen significantly elsewhere.

Frequently Asked Questions

Do I have to pay taxes on the interest I earn?

Yes. Interest is considered income by the IRS. If you earn $10 or more in interest in a year, your bank will send you a form called a 1099-INT, and you will need to report that interest on your tax return. The interest is taxed at your regular income tax rate, not at a special rate.

What if my account balance is very small — will I still earn interest?

Yes, but the amount will be very small. If you have $100 in an account earning 4.5% annual interest, you would earn about $4.50 in a year. Even small balances earn interest, but you earn more interest on larger balances. This is why it makes sense to keep money you are saving in a savings account rather than in cash, even if the amount is small.

Can the bank lower my interest rate without telling me?

Yes. Banks can change interest rates at any time without asking your permission. They usually notify you by mail or email, but the rate change is legal. If your bank lowers its rate significantly, you can move your money to a different bank offering a higher rate. There is no penalty for closing a savings account and opening one elsewhere.

What is the difference between APR and APY?

APR (Annual Percentage Rate) is the interest rate without including the effect of compounding. APY (Annual Percentage Yield) includes compounding, so it shows the actual amount you will earn in a year. Banks are required to show you the APY, which is why it is the number to compare between banks.