Interest is money the bank pays you for keeping your money with them
When you deposit money into a savings account, the bank lends that money to other customers through mortgages, car loans, and business loans. In exchange for the use of your money, the bank pays you interest—a percentage of your balance that gets added to your account on a set schedule. The more money you keep in the account and the longer you keep it there, the more interest you earn.
The amount you earn depends on three things: your account balance, the interest rate the bank offers, and how often the bank calculates and adds interest to your account. Banks are required to disclose all three of these details before you open an account, usually in a document called the Truth in Savings Act disclosure or the account terms sheet.
Key Takeaways
- Interest rates on savings accounts vary by bank and change over time, so comparing rates before opening an account can significantly affect how much you earn.
- The bank calculates interest based on your balance and compounds it—meaning you earn interest on your interest—at intervals set by the bank, usually daily or monthly.
- A higher annual percentage yield (APY) means more money in your pocket, and online banks typically offer higher rates than brick-and-mortar banks.
- Interest is taxable income, and the bank will send you a Form 1099-INT at the end of the year if you earned $10 or more in interest.
How the interest rate and APY are different
Banks advertise two different numbers, and they are not the same. The interest rate is the percentage the bank pays on your balance. The annual percentage yield (APY) is the total amount you will earn in a year after the bank compounds the interest—meaning it adds interest to your account, and then you earn interest on that interest too.
For example, if a bank offers a 4.50% interest rate and compounds interest daily, your APY will be slightly higher than 4.50% because you are earning interest on the interest that was already added. The difference is small on savings accounts but matters when you are comparing banks. Always look at the APY, not the interest rate, when deciding where to open an account.
Interest rates change based on what the Federal Reserve does with its benchmark rate. When the Fed raises rates, banks typically raise the rates they offer on savings accounts. When the Fed lowers rates, banks lower theirs. This means the rate you see today may not be the rate you earn next month.
How compounding works and why it matters
Compounding is the process of earning interest on your interest. Here is how it works: the bank calculates interest on your balance, adds it to your account, and then the next time it calculates interest, it uses the new, larger balance. Over time, this creates a snowball effect where your money grows faster than it would with straightforward interest alone.
The frequency of compounding affects how much you earn. Banks compound interest on different schedules—daily, monthly, quarterly, or annually. Daily compounding is the most common on savings accounts and earns you slightly more than monthly or quarterly compounding because the bank adds interest to your account more often. The difference is usually small, but it adds up over years.
Here is a simplified example: if you have $10,000 in an account earning 4.50% APY compounded daily, after one year you will have approximately $10,450. If the same account compounded interest only once a year, you would have the same amount. But if you leave the money there for five years, daily compounding will have earned you noticeably more than annual compounding would have.
Where interest rates differ between banks
| Bank Type | Typical APY Range | Why the Difference |
|---|---|---|
| Online banks | 4.00% to 5.35% | Lower overhead costs mean higher rates for customers |
| Credit unions | 3.50% to 5.00% | Member-owned, so profits return to account holders |
| Large brick-and-mortar banks | 0.01% to 0.50% | High operating costs and less pressure to compete on rates |
| High-yield savings accounts | 4.50% to 5.35% | Designed specifically to attract deposits with competitive rates |
The difference between a 0.01% rate at a large bank and a 5.00% rate at an online bank is enormous. On a $10,000 balance, the large bank would pay you $1 per year. The online bank would pay you $500 per year. Over five years, that is a difference of nearly $2,500 in interest earned.
Online banks and credit unions tend to offer higher rates because they have lower costs and compete directly on rate to attract customers. Large national banks often offer lower rates because they rely on brand recognition and convenience rather than competing on interest paid. If earning interest matters to you, comparing rates across different bank types before opening an account is worth the time.
Interest is taxable income
The interest you earn on a savings account is taxable income. You must report it on your federal tax return, and depending on your state, you may owe state income tax on it as well. The bank will send you a Form 1099-INT at the end of the year if you earned $10 or more in interest during that year. You use this form to report the interest on your tax return.
If you earned less than $10, the bank may not send you a form, but you are still required to report the interest if you file a tax return. Keep your own records of interest earned if the amount is small. The IRS matches the 1099-INT the bank sends them with your tax return, so reporting the correct amount is important.
What happens to interest if you withdraw money early
Interest accrues—builds up—based on your balance at the time the bank calculates it. If you have $10,000 in your account on the day the bank calculates interest, you earn interest on $10,000. If you withdraw $5,000 the next day, you do not lose the interest you already earned, but your balance is now lower, so you will earn less interest going forward.
Some savings accounts have minimum balance requirements. If your balance falls below the minimum, the bank may charge a monthly fee or stop paying interest altogether. Check your account terms to see whether your account has a minimum balance and what happens if you fall below it. Most online banks and credit unions have no minimum balance requirement, which makes them more flexible if you need to withdraw money.
How to maximize the interest you earn
The most direct way to earn more interest is to keep a higher balance in your account. If you have $50,000 instead of $10,000, you will earn five times as much interest at the same rate. The second way is to find an account with a higher APY. Comparing rates across banks takes 15 minutes and can mean hundreds of dollars more per year.
A third strategy is to move money into a high-yield savings account only when you know you will not need it for a few months. Regular savings accounts at large banks often pay almost nothing, but high-yield accounts at online banks pay significantly more. If you need quick access to the money, a high-yield savings account is still better than a checking account, which typically pays no interest at all.
Avoid accounts that require you to maintain a very high minimum balance or that charge fees that eat into your interest earnings. A $15 monthly fee on an account earning $20 per year in interest means you are losing money. Read the fee schedule in the account terms before you open the account.
Frequently Asked Questions
Can the bank lower my interest rate after I open the account?
Yes. Banks can change the interest rate on savings accounts at any time, and they usually lower rates when the Federal Reserve lowers its benchmark rate. You are not locked into a rate. If your bank lowers the rate significantly, you can move your money to a different bank that offers a higher rate.
What is the difference between a savings account and a money market account?
Money market accounts often pay slightly higher interest than regular savings accounts, but they usually require a higher minimum balance and limit how many withdrawals you can make per month. If you need frequent access to your money, a savings account is usually the better choice. If you are saving for a specific goal and do not need to touch the money often, a money market account may pay more.
Do I earn interest on interest in a savings account?
Yes, through compounding. The bank adds interest to your balance, and then the next time it calculates interest, it uses the new balance that includes the interest you already earned. This is why daily compounding pays slightly more than monthly or annual compounding—the bank is adding interest more frequently, so you earn interest on your interest more often.
What happens to my interest if the bank fails?
Your deposits and the interest you have earned are protected by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per account holder per bank. This means if the bank fails, you will get your money back, including any interest that had been added to your account. Credit unions are protected by the National Credit Union Administration (NCUA) with the same $250,000 limit.
Why do some banks offer promotional interest rates?
Banks sometimes offer higher rates for a limited time to attract new customers. These promotional rates usually last three to six months, and then the rate drops to the regular rate. Read the terms carefully to see when the promotional rate ends and what the regular rate will be. If the regular rate is much lower, you may want to move your money when the promotion ends.