Banks lend out the money you deposit, and they share part of what they earn
When you put money in a savings account, the bank doesn't lock it in a vault with your name on it. Instead, the bank uses your deposit to lend money to other customers—for mortgages, car loans, business loans, and other purposes. The borrowers pay the bank interest on those loans. The bank keeps some of that interest as profit, and passes some of it back to you as interest on your savings account.
This is the basic trade: you let the bank use your money, and the bank compensates you for that use. The interest rate the bank offers you depends on how much interest the bank can earn by lending your money out, minus what it costs the bank to operate and what it needs to keep as a safety cushion.
The amount of interest you earn is not fixed by law or by any single authority. Each bank sets its own rate based on what it thinks it can afford to pay while still making a profit. That's why rates vary widely between banks, and why they change over time.
Key Takeaways
- Banks lend out customer deposits to borrowers and share a portion of the interest they collect with account holders.
- The interest rate you receive reflects what the bank can earn from lending, minus operating costs and required reserves.
- Banks compete for deposits by offering higher rates, so rates vary significantly between institutions.
- The Federal Reserve's interest rate decisions influence how much banks can earn and therefore how much they offer savers.
- Interest rates on savings accounts are not may provide and can change at any time.
How the Federal Reserve's rate affects what your bank pays you
The Federal Reserve (the central bank of the United States) sets a target range for the interest rate that banks charge each other when they lend overnight. This is called the federal funds rate. When the Fed raises this rate, banks' borrowing costs go up, which means banks can afford to pay savers more. When the Fed lowers the rate, banks' costs go down, and they typically lower the rates they offer savers.
Your bank doesn't directly follow the Fed's rate—there's no rule that says it must. But the Fed's rate influences the entire lending market. When the Fed raises rates, mortgage rates, car loan rates, and credit card rates all tend to rise. Banks earn more from lending, so they can afford to offer higher savings rates to attract deposits. When the Fed cuts rates, the opposite happens.
The lag between a Fed rate change and a change in your savings account rate is usually a few weeks to a few months. Some banks move quickly; others move slowly. And some banks raise rates faster than they lower them, which is why it pays to shop around when rates are falling.
Why different banks offer different rates
Banks are competing for your deposits. A bank that wants to grow its deposit base will offer a higher rate. A bank that already has plenty of deposits might offer a lower rate because it doesn't need to attract more money right now.
Online banks typically offer higher rates than traditional brick-and-mortar banks because they have lower overhead costs—no branch buildings, fewer employees, no tellers. That savings gets passed along to savers in the form of higher interest rates. A traditional bank might offer 0.01% annual interest on a basic savings account, while an online bank might offer 4% or 5% on the same type of account.
Banks also offer different rates based on account type. Money market accounts often pay more than regular savings accounts. Certificates of deposit (CDs) usually pay more than savings accounts because you agree to leave your money untouched for a set period. The longer you lock your money away, the higher the rate typically is.
What happens to interest rates when the economy changes
When inflation is high, the Federal Reserve usually raises its target rate to cool down spending and bring prices back down. This makes borrowing more expensive, which discourages people from taking out loans. Higher Fed rates mean banks can earn more from lending, so they offer higher savings rates to attract deposits. This is why savers often see better rates during periods of high inflation.
When the economy slows down and unemployment rises, the Fed typically lowers rates to encourage borrowing and spending. Lower Fed rates mean banks earn less from lending, so they offer lower savings rates. This is why savings rates are often very low during recessions or periods of economic weakness.
The relationship is not perfectly predictable—banks make their own decisions about rates based on their own financial situation and strategy. But the general pattern holds: Fed rate increases tend to lead to higher savings rates, and Fed rate decreases tend to lead to lower savings rates.
How interest compounds and grows your balance
Most savings accounts use compound interest, which means the bank calculates interest on your original deposit plus any interest you've already earned. The more frequently interest compounds, the more you earn.
For example, if you deposit $1,000 in an account earning 4% annual interest compounded daily, the bank divides the 4% by 365 days and calculates interest each day on your current balance. That daily interest gets added to your balance, and the next day's interest is calculated on the new, slightly higher balance. Over a year, this daily compounding adds up to more than if the bank calculated interest once at the end of the year.
The difference between daily compounding and annual compounding is usually small on savings accounts, but it adds up over time, especially on larger balances. When you're comparing savings accounts, look at both the interest rate and the compounding frequency.
Why some accounts earn more interest than others
High-yield savings accounts earn significantly more than regular savings accounts at the same bank because they are designed to attract deposits. These accounts often have higher minimum balance requirements or other restrictions, but the interest rate is the main draw.
Money market accounts typically earn more than savings accounts because they function as a hybrid between a savings account and a checking account. You can write checks or make transfers, but the account is designed for saving rather than frequent spending. Banks reward this by paying higher interest.
Certificates of deposit (CDs) earn more than savings accounts because you commit to leaving your money in the account for a set term—three months, six months, one year, five years, or longer. The longer the term, the higher the rate. In exchange, you pay a penalty if you withdraw the money before the term ends.
Money market funds and Treasury bills are not bank products, but they also earn interest. Money market funds invest in short-term debt, and Treasury bills are loans to the federal government. Both pay interest, and rates vary based on market conditions and the length of the commitment.
What you should know about interest rate risk
Interest rates are not may provide. Your bank can lower the rate on your savings account at any time, with notice (usually 30 days). If rates fall, your earnings fall with them. This is why it's worth checking your current rate periodically and comparing it to what other banks are offering.
If you lock money into a CD at a certain rate and rates rise, you're stuck with the lower rate unless you withdraw early and pay the penalty. This is the trade-off of a CD: you get a higher rate in exchange for giving up flexibility.
If you keep money in a regular savings account and rates fall, you earn less, but you can move your money to a different bank at any time without penalty. This flexibility is worth something, even if it means accepting a slightly lower rate.
Frequently Asked Questions
Why is my savings account earning almost no interest?
Your bank may be offering a very low rate because it already has plenty of deposits and doesn't need to attract more money. Online banks and some credit unions typically offer much higher rates on the same type of account. You can move your money to a higher-paying bank without penalty.
Does the interest I earn count as income for taxes?
Yes. Interest earned on savings accounts is taxable income. Banks report interest over $10 to the IRS on a Form 1099-INT. You report this interest on your tax return. The amount is usually small unless you have a large balance or a high interest rate.
Can a bank take away the interest I've already earned?
No. Once interest is credited to your account, it's yours. The bank can lower the rate it offers on future interest, but it cannot remove interest that has already been added to your balance. Your account balance is also protected by FDIC insurance up to $250,000 per bank.
What's the difference between APY and APR on a savings account?
APY (annual percentage yield) includes the effect of compound interest, so it's the actual amount you'll earn over a year. APR (annual percentage rate) does not include compounding. Banks are required to show you the APY, which is the number that matters for savings accounts.
If I move my money to a different bank, do I lose the interest I've earned?
No. The interest you've earned stays in your account and moves with you. When you transfer money to a new bank, the full balance—original deposit plus all earned interest—transfers. You only lose future interest if you move the money before the next interest payment date.