Interest is money the bank pays you for letting them hold your deposits

When you put money in a savings account, the bank lends that money to other customers through mortgages, car loans, and business credit lines. In exchange, the bank pays you interest—a percentage of your balance, calculated and added to your account on a schedule the bank sets. The rate the bank offers you is called the annual percentage yield, or APY. That rate is what you'll see advertised, and it's the number that matters when you compare accounts.

The actual mechanics are simpler than they sound. The bank takes your balance on certain days, applies the interest rate to it, and deposits the interest directly into your account. You don't do anything. The money just appears. How often this happens—daily, monthly, quarterly—depends on the account and the bank. The more frequently interest is added, the more you earn, because you start earning interest on the interest itself. This is called compounding.

Key Takeaways

  • The APY shown on a savings account is the annual rate the bank will pay you; it already accounts for how often interest compounds, so you can compare accounts directly.
  • Interest is calculated on your balance and added to your account on a schedule set by the bank—usually daily, monthly, or quarterly.
  • The more frequently interest compounds, the more total interest you earn over time, even if the APY is the same.
  • Your balance can go down if you withdraw money, and interest is recalculated on the new, lower balance.
  • Banks can change the APY at any time on most savings accounts, so the rate you see today may not be the rate you earn next month.

How the bank calculates the interest you earn each period

The bank uses a formula: your current balance, multiplied by the APY, divided by the number of days in a year, multiplied by the number of days in the period. If your balance is $10,000, the APY is 4.5%, and interest is calculated daily, the bank divides 4.5% by 365 days to get a daily rate of about 0.0123%. That daily rate is applied to your $10,000 balance, earning you roughly $1.23 that day. The next day, if your balance is still $10,000, you earn another $1.23. If you deposit $5,000 on day three, your new balance is $15,000, and the daily interest jumps to about $1.85.

The key point: interest is always calculated on the balance you actually have on the day it's calculated. If you withdraw $5,000 midway through a month, the bank recalculates the interest for the rest of that month using the lower balance. You don't lose interest you've already earned—that stays in your account—but you stop earning interest on the money you withdrew.

Compounding: earning interest on your interest

When the bank adds interest to your account, that interest becomes part of your balance. The next time interest is calculated, it's calculated on the original balance plus the interest you've already earned. This is compounding, and it's the reason the actual amount you earn is slightly higher than a straightforward calculation would suggest.

Here's a concrete example. You deposit $10,000 in an account with a 4.5% APY, and interest compounds daily. On day one, you earn about $1.23 in interest. Your balance is now $10,001.23. On day two, the bank calculates interest on $10,001.23, not just the original $10,000. You earn about $1.23 plus a tiny fraction of a cent on the $1.23 you earned yesterday. Over a year, this compounding effect adds up. With daily compounding at 4.5% APY, $10,000 grows to $10,460.13—not $10,450, which is what you'd earn with no compounding. The difference is small on short timescales, but it grows larger the longer your money sits and the higher the rate.

Why the APY already includes compounding in the number you see

Banks advertise the APY, not the annual percentage rate (APR). The difference matters. The APR is the straightforward interest rate without compounding. The APY is the rate you actually earn after compounding is factored in. When a bank shows you 4.5% APY, that 4.5% already assumes daily, monthly, or quarterly compounding—whatever schedule that bank uses. You don't have to do any math to account for compounding yourself. The APY is the real number.

This is why you can compare two banks directly by looking at their APYs. If Bank A offers 4.5% APY and Bank B offers 4.3% APY, Bank A will earn you more money over a year, regardless of how often each bank compounds interest. The APY takes that into account.

How often interest is added to your account

Banks vary in how frequently they calculate and add interest. Some calculate daily but add it monthly. Others calculate and add daily. A few still calculate and add quarterly. The schedule is set by the bank and is usually stated in the account disclosure document you receive when you open the account.

Daily compounding is the most common for online savings accounts and high-yield savings accounts. Traditional brick-and-mortar banks often compound monthly or quarterly. The difference in total earnings between daily and monthly compounding is small—usually less than 0.1% of your balance per year—but it's real. If you're comparing two accounts with the same APY, the one that compounds more frequently will earn you slightly more.

Interest rates change, and banks can lower yours without warning

The APY you see when you open an account is not locked in. Banks can change the rate on most savings accounts at any time, for any reason. When the Federal Reserve raises or lowers its benchmark interest rate, banks typically adjust the rates they offer on savings accounts within days or weeks. When rates fall, your APY falls with it. When rates rise, your APY may rise, but not always as quickly or as much.

You'll receive notice of a rate change, usually by email or mail, but the bank is not required to ask your permission. The new rate straightforward takes effect on the date the bank specifies. If you're unhappy with the new rate, you can move your money to a different bank, but you'll have to close the account and open a new one elsewhere. There's no penalty for withdrawing your money from a savings account—you can take it out anytime—but you may lose a few days of interest if you withdraw before the interest posting date.

What happens to interest if you withdraw money early

Savings accounts have no early withdrawal penalty. You can take out money whenever you want, and you keep all the interest you've already earned. However, the interest you earn going forward is calculated on the new, lower balance. If you have $10,000 earning 4.5% APY and you withdraw $5,000, the remaining $5,000 will earn interest at the same 4.5% APY, but the daily interest amount drops from about $1.23 to about $0.62.

Some banks calculate interest on a minimum balance or an average balance over the month, rather than the actual balance each day. If your bank uses average balance, withdrawing money partway through the month may reduce the interest you earn for that entire month, not just the days after the withdrawal. Check your account disclosure to see which method your bank uses.

Frequently Asked Questions

Is the APY the same as the interest rate?

No. The interest rate (APR) is the straightforward percentage before compounding. The APY is the actual rate you earn after compounding is included. Banks advertise APY because it's the real number. When comparing accounts, always look at the APY.

Can I lose money in a savings account?

No. Your balance can only stay the same or go up. Interest is always added, never subtracted. Your balance goes down only when you withdraw money yourself. Savings accounts are insured by the FDIC up to $250,000 per depositor per bank.

Why do different banks offer different APYs?

Banks set their own rates based on how much they need deposits and what they can earn by lending that money out. Online banks often offer higher APYs than traditional banks because they have lower overhead costs. Rates also change based on what the Federal Reserve does with its benchmark rate.

Does interest get taxed?

Yes. Interest earned in a savings account is taxable income. Banks report interest over $10 to the IRS on a Form 1099-INT. You'll owe federal income tax on the interest, and possibly state income tax depending on where you live. The bank does not withhold this tax automatically.

What if the bank changes the APY after I open the account?

The bank can lower the APY at any time without your permission. You'll receive notice, but you cannot prevent the change. You can move your money to a different bank if the new rate is too low. There's no penalty for closing a savings account or withdrawing your balance.