APY vs. Interest Rate: What’s the Difference? (original) (raw)

When you’re comparing various savings vehicles such as savings accounts, interest-bearing checking accounts, certificates of deposit (CDs) or money market accounts, it’s important to understand how different rates are quoted.

Key Takeaways

APY includes compound interest over a year, while the interest rate is the simple rate without compounding
APY is higher than the interest rate due to compounding
Understanding APY versus interest rates helps you make better financial decisions and maximize your returns

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What’s the Difference Between APY and Interest Rate?

The interest rate, sometimes called the nominal rate, is the percentage of interest you earn or pay on the principal amount without considering any compounding. It gives you a basic idea of how much you’ll earn or pay over a set period of time. On the other hand, the APY includes compounding interest. It gives you a better picture of the total interest you’ll actually earn in a year. When your interest compounds, you earn interest on both the principal and the accumulated interest to date.

Because of compounding, the APY will always be higher than the nominal interest rate when it’s compounded more frequently than once per year. This distinction matters because a higher APY means you’ll earn more interest over time, even if the nominal rates are similar for different accounts.

Here’s an example:

Comparing Earning Opportunities

Let’s say you want to choose one of two banks to deposit 1,000into.BankAoffersacheckingaccountwithaninterestrateof51,000 into. Bank A offers a checking account with an interest rate of 5%, compounded annually, and Bank B has a savings account with a rate of 5%, but it’s compounded monthly. With Bank A, your interest will compound only once at the end of the year, resulting in a 1,000into.BankAoffersacheckingaccountwithaninterestrateof550 earning. But with Bank B, you will earn slightly more because the interest is compounded each month using the principal plus the interest earned from the previous periods. This results in an earning of about $51.16.

What Is Annual Percentage Yield (APY)?

APY is a measure of the total percentage of interest earned in one year. Unlike the simple interest rate, which only calculates interest earned on the principal, APY accounts for compounded interest on both the principal and prior interest earned.

Interest can compound daily, monthly, quarterly or annually, depending on the bank. The more often it compounds, the higher the APY. This is because you earn interest on the principal the first period, then you earn interest on the total amount (principal + interest) the next period, and so on.

How to Calculate APY

Here’s how it works: To calculate APY, you can use the standard formula: APY = (1+r/n)^n – 1

r = interest rate (as a decimal)

n = number of compounding periods per year

For example, if the interest rate is 5% (0.05) and the interest is compounded monthly, meaning 12 times per year (n = 12), the APY would be calculated like this:

APY = (1 + 0.5/12)^12 – 1 ≈ 0.0512 (5.12%)

So, if you deposited 1,000intothisaccount,itwouldearnapproximately1,000 into this account, it would earn approximately 1,000intothisaccount,itwouldearnapproximately51.16.

Final amount for the first year: 1,000×1.0512≈1,000 × 1.0512 ≈ 1,000×1.0512≈1,051.16

What Is Interest Rate?

An interest rate (sometimes called a nominal rate) is the percentage charged by lenders or paid to deposit account holders on the principal amount of the loan or deposit. For savers, the interest rate is the percentage of the deposited funds that the bank will pay the account holder.

Interest rates differ from APYs because they don’t take compounding periods into account. In other words, it’s a simple rate that could be used if you were to deposit your money into an account that will only compound once per year and you only want to see how much it will earn in that first year.

How APY Impacts Savings and CDs

When you invest in a savings account or CD, the APY calculation takes the compounding frequency into account. This means the interest earned is added back to the principal, and future interest calculations are made based on this increased balance.

Example

If you have a savings account that compounds annually and a CD that compounds monthly – both with a 5% interest rate – you’ll have better yields with the CD. The APY for the savings account is exactly 5%, but the CD ends up having an APY of approximately 5.12% because of its more frequent compounding. This might seem like a small difference, but over time, the impact of that compounding can be significant.

Comparing APY When Choosing Accounts

When comparing different savings accounts and CDs, compare APYs rather than just interest rates. The APY will give you a better idea of how much you can earn with each one. Some financial institutions might advertise a high interest rate, but only compound quarterly or annually. It’s important to take that frequency into consideration.

Look for accounts with the highest APYs, since these will grow your money faster.

Other Factors to Consider Besides APY

While maximizing APY is important, it’s not the only thing to look at.

One factor to consider is the minimum deposit requirement. Some accounts that offer high APYs also require you to deposit a larger amount of money and/or keep a higher minimum balance. This might not be feasible for everyone, particularly if it’s a CD that requires you to keep your money tied up for a specific period of time.
Also, look at fees. Some accounts have monthly maintenance fees or other charges that can eat into your earnings. CDs also have early withdrawal penalties you’ll have to pay if you decide you need the money before it matures. Always read the fine print and subtract all the fees into your projected earnings.
Finally, decide how accessible you need your funds to be. Some high-yield savings accounts might limit the number of withdrawals you can make, and CDs have penalties for withdrawing your money early. If you need access to your funds in case of emergency, try balancing a high APY with a more flexible account.

FAQ: APY vs. Interest Rate

The annual percentage yield (APY) is typically higher than the interest rate because it includes interest compounded over time. Interest rates only reflect simple interest on the initial deposit (principal), assuming it’s only compounded one time in a year. But APYs account for how interest is earned on the principal balance, plus any interest earned in previous compounding periods.

Some banks offer savings accounts with APYs that compound daily. For these accounts, interest is calculated and added to the balance every day.

No, the APR (annual percentage rate) and APY (annual percentage yield) are not the same. APR is the rate you’ll pay on a loan, including interest and fees. APY is the amount an institution pays you to keep your money there.

APY is used for savings and other investment accounts. It’s the amount of interest you can earn on your deposit. APR, on the other hand, is used for loans, credit cards and other credit products. It’s the annual cost of borrowing the money, including interest and fees.

*Data accurate at time of publication

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