The interest a bank pays is not a single yearly payment but the result of a daily calculation you rarely see. Most banks apply a small daily rate to your balance, add up the interest across the month, and then credit it to your account. Once credited, that interest joins your balance and begins earning interest itself. Understanding this process explains why your posted interest varies month to month and how to earn a little more.
The daily periodic rate
Most deposit accounts use a daily balance method, applying a daily periodic rate to the money in the account each day. The daily rate is the nominal annual rate divided by the number of days in the year, so a 3.65 percent annual rate works out to roughly 0.01 percent per day. The bank multiplies that daily rate by your balance to find each day's interest. Days with a higher balance earn more, which is why a large deposit early in the cycle earns more than the same deposit made late.
Accrual versus crediting
Interest accrues daily but is usually credited, or posted, to your account only at the end of the statement cycle, often monthly. Accrued interest is interest you have earned but not yet received, while credited interest has been added to your balance. The distinction matters because only credited interest starts compounding. If you close an account mid-cycle, some banks pay the accrued interest and some do not, so it is worth checking.
How compounding fits in
Once interest is credited to your balance, the next cycle's daily calculation runs on the new, larger balance, so you earn interest on your interest. The more frequently a bank credits interest, the sooner compounding kicks in, which is part of why APY can exceed the nominal rate. Leaving credited interest in the account keeps the compounding chain intact. Withdrawing interest as it posts turns compound growth into simple interest.
What changes your monthly interest
Your posted interest varies with your average balance during the cycle and the number of days in that cycle, so a February payment is naturally smaller than one for a longer month. Adding money earlier in the cycle earns more days of interest than adding it at the end. A variable rate that moves mid-cycle also shifts the total. Banks report interest of 10 dollars or more for the year on a 1099-INT form for your taxes.
You keep about 10,000 dollars in a savings account at 3.65 percent, a daily rate near 0.01 percent, earning roughly 1 dollar of interest each day. Over a 30-day month that accrues to about 30 dollars, which the bank credits to your balance so the next month's interest is calculated on 10,030 dollars.
Key takeaways
- Banks typically apply a daily periodic rate to your balance and accrue interest each day.
- Interest is credited monthly, and only credited interest begins compounding.
- A higher balance held for more days of the cycle earns more interest.
- Interest of 10 dollars or more per year is reported to you and the IRS on a 1099-INT.
Common mistakes
- Assuming interest is a single yearly payment rather than a daily accrual credited monthly.
- Adding a large deposit at the end of the cycle and earning only a few days of interest on it.
- Withdrawing interest as soon as it posts and losing the compounding benefit.
FAQ
Why was my interest payment different this month?
Posted interest depends on your average daily balance and the number of days in the cycle, so a shorter month or a lower average balance produces a smaller payment.
Do I owe taxes on bank interest?
Yes, interest is taxable income, and banks report annual interest of 10 dollars or more on a 1099-INT form that you include on your tax return.