If you’re looking at savings accounts, APY is crucial for understanding your actual rate of return
If you want to maximize your money and earn interest on the funds you put into a savings account or certificate of deposit (CD), there’s one major thing to look out for: the annual percentage yield or APY.
This number can determine how much your money grows over time.
What is APY?
The annual percentage yield (APY) is the interest earned on a deposit account balance within a year and is expressed as a percentage.
“APY is the annual percentage yield and outlines the real rate of return earned, which takes into account the compounding interest,” says Jason Noble, financial adviser and partner at Prime Capital Advisor.
This compounding factor is what sets APY apart from simple interest. The APY on your account, which sets the rate of growth on the money you put away, can vary by bank and the type of savings vehicle. For example, online banks may offer a more attractive APY than brick-and-mortar banks.
The types of accounts that offer APY on deposits include high-yield savings accounts and traditional savings accounts, CDs, and money-market accounts. Some checking accounts may also offer an APY to help you earn interest.
How APY works
When opening a deposit account such as a savings account or CD, you can make an initial deposit to kick-start your savings journey. That’s when APY will begin to accrue interest on your balance over the course of a year.
What makes APY so useful to savings is that it’s calculated using compound interest.
Compounding interest has a snowball effect that can help savers grow their money at a faster rate by earning additional interest on top of their deposits and earnings earned within previous months.
“Compounding interest is the interest you earn on the original investment and its initial interest,” says Noble. “For instance, if you have $100 that earns 1.5% interest each year, you will have $101.50 at the end of the first year. At the end of the second year, you would have $103.02. So you earned 1.5% on the entire $101.50, not just the original $100.”
Through compounding interest, you can earn even more on your deposits without any extra effort. Of course, how much you earn will be largely based on the APY associated with the savings vehicle and the rate of compounding—and any additional funds you deposit into the account.
In some cases, the APY on an account can fluctuate over time. As such, the APY can increase or decrease at any time. These changes are typically correlated with activity by the Federal Reserve. So, when it increases rates, APY on savings vehicles typically follows. When rates are lowered, that’s usually reflected in your savings account’s APY as well.
If you want an APY that is immune to these fluctuations, you can get a fixed rate with a CD. The downside is that you must commit to keeping your money in the account for a specific length of time—typically the longer the term, the higher the APY. If you tap these funds before the term is over, you could be hit with an early withdrawal penalty in addition to forfeiting the additional interest you could earn on the account.
There is a specific formula to calculate Annual Percentage Yield. The APY formula is:
APY = (1 + r/n)n – 1
The r in the equation refers to the rate, or interest rate.
The n in the equation refers to the number of compounding periods within a year.
So if you wanted to put $3,000—with no additional deposits—into a high-yield savings account earning 2% and compounds monthly (12 periods within a year), the APY formula would look like this.
(1 + .02/12)12 -1 = 0.020184
To make it a percentage, multiply that number by 100 and you get 2.0184% APY.
With an initial deposit of $3,000 you can multiply that amount by the APY ($3,000 x 2.0184%) and see how much your money would grow to within the year. Given the APY calculation, you’d have $3,060.55 at the end of the year, so you’d earn a little over $60 in interest.
The good news is you don’t have to calculate the APY on your own—banks must clearly display it for consumers to see. “The Trust in Savings Act of 1991 mandated both APR and APY be disclosed in ads and agreements,” explains Noble.
If you’re reviewing and comparing savings vehicles, you can use an online APY calculator to compare different rates.
Aside from looking at the APY and understanding whether it’s fixed or variable, you want to understand the compounding schedule as well. For example, some accounts may compound daily, monthly, or annually. You can earn even more interest if your savings accounts compound at a higher frequency, such as daily or monthly.
APY vs. APR
When comparing different financial products, you’ll likely see the abbreviations APY and APR, or annual percentage rate. Though these terms seem similar, they’re generally used for different types of financial products. Both are used as tools by banks and lenders to attract customers to save or borrow with them.
So while APY refers to money you’ll earn on a deposit account, APR refers to the interest rate you’re charged on loan products, such as auto loans and mortgages. Another difference between the two is compounding interest.
“The difference between APR and APY is that APR does not factor in compound interest,” says Andre Jean-Pierre, investment adviser and founder of Aces Advisors Wealth Management. “These rates are typically used to advertise by lenders for loans and credit cards. Because compound interest is not factored, the rate will appear lower, thus more attractive to advertise to borrowers.”
Here’s a breakdown of the major differences between APY vs. APR.
There are many numbers, like APY and APR, to look at carefully when deciding what financial products to use. If you see a number that looks more attractive than another, it makes sense to run the numbers to understand the big picture and how it might ultimately benefit—or cost—you.
“Many banks will advertise their savings accounts with APYs, and in very small font show their APRs, to show the larger of the two numbers,” says Noble, “while many lenders will do the exact opposite and show the APR in big letters, while keeping the APYs a lot smaller.”
Though savings options are generally marketed with APY and loan products with APR, you may still want to run both calculations especially when borrowing. Remember, APY takes into account compounding, whereas APR doesn’t. As compound interest can boost your savings, it can also add to your debt. So one number may appear better than another, but it doesn’t give you the full context.
“To avoid this gimmick, run both in a calculator, and it will show you the true numbers so you can make an informed decision. If you are taking out a loan, make sure to look into the APY, as that will prove to be a more reliable number for what you will pay over time,” says Noble.
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