To calculate interest on a savings account, you need three pieces of information: your balance, the interest rate, and how often the bank compounds your interest. The standard compound interest formula is A = P(1 + r/n)^(nt), where P is your starting balance, r is the annual interest rate as a decimal, n is the number of times interest compounds per year, and t is the number of years. The result, A, is your total balance after interest. Subtract your original deposit to see how much interest you earned.
The Compound Interest Formula
Nearly all savings accounts use compound interest, meaning the interest you earn gets added to your balance, and then future interest is calculated on that larger amount. Here’s how to use the formula with a real example.
Say you deposit $5,000 into a savings account paying 4% annual interest, compounded monthly. You want to know how much you’ll have after one year.
- P (principal): $5,000
- r (annual interest rate): 0.04 (convert the percentage to a decimal by dividing by 100)
- n (compounding periods per year): 12 (once per month)
- t (time in years): 1
Plug those in: A = 5,000 × (1 + 0.04/12)^(12×1). That simplifies to 5,000 × (1.00333)^12, which equals roughly $5,203.71. Your interest earned is $203.71. If you’d used simple interest (no compounding), you would have earned exactly $200, so the compounding added an extra $3.71 in this case. Over longer time periods, that gap widens dramatically.
Why Compounding Frequency Matters
Banks compound interest on different schedules: daily, monthly, quarterly, or annually. The more frequently interest compounds, the more you earn, because each round of interest gets folded into the balance sooner and starts generating its own interest.
Using a $10,000 deposit at 10% interest over 10 years, the difference becomes clear. Annual compounding produces $15,937 in total interest. Switch to quarterly compounding and that rises to $16,851. Monthly compounding pushes it to $17,060. That’s over $1,100 more just from compounding monthly instead of annually, with the same rate and the same deposit. Most online savings accounts today compound daily, which squeezes out a bit more than monthly compounding.
When comparing accounts, don’t worry too much about doing the math yourself for each compounding frequency. Instead, look at the APY, which accounts for compounding automatically.
Interest Rate vs. APY
Banks advertise two numbers that look similar but mean different things. The interest rate is the base percentage your money earns before compounding is factored in. The APY (Annual Percentage Yield) reflects what you actually earn over a full year after compounding is included.
For example, a bank might offer a 4.85% interest rate that compounds daily. Because daily compounding adds interest to your balance 365 times a year, the APY works out to roughly 4.97%. The APY is always equal to or higher than the stated interest rate. When you’re shopping for a savings account, compare APYs rather than base rates. Two accounts could advertise the same interest rate but produce different returns if one compounds daily and the other compounds monthly.
If you know the APY and just want a quick estimate of your yearly earnings, multiply your balance by the APY as a decimal. A $10,000 balance at 4.97% APY earns about $497 in one year, assuming you don’t add or withdraw money.
How Banks Handle Changing Balances
The formula above assumes your balance stays the same, but real savings accounts have deposits and withdrawals throughout the month. Banks typically use the average daily balance method to handle this. They record your balance at the end of each day, add up all those daily balances, and divide by the number of days in the period to get an average. Interest is then calculated on that average.
Here’s a simplified example. Suppose your account starts the month with $3,000. On day 11, you deposit $500, bringing the balance to $3,500 for the rest of the 30-day month. The bank calculates: (10 days × $3,000) + (20 days × $3,500) = $100,000. Divide by 30 days, and your average daily balance is $3,333.33. The bank applies the daily interest rate to that figure.
The daily interest rate is your annual rate divided by 365. At 4% annual interest, that’s about 0.01096% per day. Multiply $3,333.33 by 0.0001096 by 30 days, and you’d earn roughly $10.96 in interest for that month. This is the same math the bank runs automatically, so you’ll see the result posted to your account at the end of each statement period.
A Shortcut for Quick Estimates
If you don’t want to work through the full formula, there are two fast approaches. For a one-year estimate with no deposits or withdrawals, just multiply your balance by the APY. A $20,000 balance at 5% APY earns approximately $1,000 in a year.
For a monthly estimate, divide the APY by 12 and multiply by your balance. Using the same numbers: 5% ÷ 12 = 0.4167% per month. Multiply $20,000 by 0.004167, and you get about $83 per month. This slightly underestimates your actual earnings because it doesn’t capture the compounding effect within each month, but it’s close enough for planning purposes.
For anything more complex, like regular monthly deposits over several years, an online compound interest calculator will save you time and give you a precise answer.
Taxes on Interest Earned
Interest earned in a savings account counts as taxable income. If you earn $10 or more in interest during the year, your bank is required to send you a Form 1099-INT reporting the amount. You’ll also get a copy from the IRS. Even if you earn less than $10 and don’t receive a form, you’re still technically required to report the interest on your tax return.
The interest is taxed as ordinary income at your regular federal tax rate, and your state may tax it as well. Keep this in mind when calculating your real return. If you earn $500 in interest and you’re in the 22% federal tax bracket, you’ll owe $110 in federal tax on that interest, leaving you with $390 in after-tax earnings.