Interest is money your bank pays you for keeping money in your account

When you deposit money into a savings account, the bank lends that money to other customers — for mortgages, car loans, credit cards, and business loans. In exchange for the use of your money, the bank pays you interest, which is a percentage of your balance. The more money you keep in the account and the longer you keep it there, the more interest you earn.

Interest is calculated and added to your account on a schedule set by your bank — usually monthly or daily. You do not have to do anything to earn it. The interest straightforward appears in your account as a credit, and from that point forward, you earn interest on the interest too (called compounding). This is why leaving money untouched in a savings account, even for a short time, can add up.

Key Takeaways

  • Interest rates vary by bank and change over time, so comparing rates between banks before opening an account can increase what you earn.
  • Online banks typically offer higher interest rates than brick-and-mortar banks because they have lower operating costs.
  • The interest rate your bank advertises is an annual percentage rate (APY), which already includes the effect of compounding.
  • Money market accounts and certificates of deposit (CDs) often pay higher rates than regular savings accounts, but with trade-offs in how quickly you can access your money.

How interest rates are set and why they change

Your bank decides what interest rate to offer based on what the Federal Reserve does with its own rates. When the Federal Reserve raises its rates, banks have more incentive to pay higher rates on savings accounts to attract deposits. When the Federal Reserve lowers its rates, banks lower the rates they pay to savers. This is why the interest rate you see advertised today may be different from the rate you see next month.

Banks also set rates based on competition. If one bank in your area offers a much higher rate than others, customers move their money there, forcing other banks to raise their rates to keep deposits. Online banks, which have fewer physical locations and lower costs to operate, often offer higher rates than traditional banks in your neighborhood.

The difference between APY and interest rate

Banks advertise a rate called the APY, or annual percentage yield. This is not the same as the basic interest rate. APY includes the effect of compounding — the way interest earns interest — so it shows you the real amount you will earn in a year. The basic interest rate (called the APR in some contexts) does not include compounding, so it will always be slightly lower than the APY.

When you are comparing savings accounts at different banks, always compare the APY, not the basic rate. A bank advertising a 4.5% APY will earn you more money than a bank advertising a 4.5% basic rate, even though the numbers look the same.

Where to find higher interest rates

Online banks almost always pay more interest than banks with physical branches. They have lower costs — no tellers, no building rent, no security staff — so they pass some of that savings to customers in the form of higher rates. If you are comfortable banking online and do not need to visit a branch in person, an online savings account will earn you significantly more money over time.

You can compare current rates across banks using websites that track savings account rates, though you will need to visit each bank's website to confirm the rate before opening an account. Rates change frequently, so a rate you see listed today may be different by the time you explore.

Money market accounts and CDs pay more, but with limits

A money market account is a hybrid between a checking account and a savings account. It typically pays a higher interest rate than a regular savings account, but it limits how many withdrawals you can make per month. If you do not need to touch your money often, a money market account can earn you more interest with minimal extra effort.

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, or longer. In exchange, the bank pays you a higher interest rate than a savings account. The longer you agree to lock up your money, the higher the rate. If you withdraw the money before the term ends, you pay a penalty, usually a few months' worth of interest. CDs work well if you have money you know you will not need for a specific amount of time.

How compounding works in your favor

Compounding means your interest earns interest. If you have $1,000 in an account earning 4% APY, after one month you earn roughly $3.33 in interest (one-twelfth of 4% of $1,000). That $3.33 is added to your account, so now your balance is $1,003.33. Next month, you earn 4% on $1,003.33, not just the original $1,000. The extra $0.01 in interest that month comes from the interest you already earned.

This effect is small in the first few months, but it grows over time. The longer money sits in an account, the more compounding works in your favor. This is why starting to save early, even with small amounts, can result in significantly more money years later.

What happens to interest if you withdraw money

Interest is calculated on your average balance or your ending balance, depending on the bank. If your bank calculates interest on your average balance and you withdraw a large amount partway through the month, you will earn less interest that month because your average balance was lower. If your bank calculates interest on your ending balance, only the money you have at the end of the period counts.

Check your account agreement or ask your bank how it calculates interest. Some banks also have minimum balance requirements — if your balance drops below a certain amount, you earn no interest that month or you pay a fee. Knowing these rules helps you keep enough money in the account to earn the full interest without paying penalties.

Frequently Asked Questions

Is the interest I earn on a savings account taxable?

Yes. Interest earned on a savings account is considered income by the IRS. Your bank will send you a form called a 1099-INT at the end of the year if you earned $10 or more in interest. You report this on your tax return. The amount of tax you owe depends on your overall income and tax bracket.

Can I move my money to a different bank if I find a better interest rate?

Yes. You can open a new account at another bank and transfer your money whenever you want. There is no penalty for switching banks with a regular savings account. Some banks offer incentives to new customers, such as a cash bonus for opening an account and depositing a minimum amount.

What is the highest interest rate I can expect right now?

Interest rates change based on what the Federal Reserve does, so the highest rate available varies month to month. Online banks currently tend to offer the highest rates, but you should check current rates directly on bank websites rather than relying on older information. Rates for savings accounts are typically lower than rates for CDs or money market accounts.

If I have very little money to save, is it worth opening a savings account?

Yes. Even small amounts earn interest, and the habit of saving regularly matters more than the size of your first deposit. Many banks have no minimum balance requirement, so you can open an account with $1 and add to it over time. The interest may seem small at first, but it grows as your balance grows.