You may not receive a financial windfall, but you’ll still reap benefits when you deposit money into a savings account, certificate of deposit or money market account and watch it begin to grow thanks to the power of interest.
The annual percentage yield, or APY, represents the real rate of return that you earn in 12 months on money deposited in an account, factoring in the effect of compounding interest. The higher the APY, the faster your money grows. Compounding interest is calculated periodically -- be it daily, monthly, quarterly -- and is added back into the balance of the account. As the account balance gets a bit larger, so too does the interest paid on the balance.
Read on to learn more about APY, other types of yields, and how they work.
What’s the difference between a fixed and variable APY?
Unlike a fixed APY, a variable APY fluctuates as interest rates change. If the Federal Reserve raises interest rates, for example, the APY for deposit accounts at some banks and credit unions will rise. Likewise, when rates decrease, APYs can go down. This applies mainly to savings accounts and CDs.
How to calculate APY
Here’s the formula for calculating the annual percentage yield:
APY = (1+i/n)ⁿ – 1
- i = interest rate.
- n = number of times the interest is compounded. If quarterly, it compounds four times. If monthly, it compounds 12 times.
Using this formula, you can estimate the amount of interest earned on a $10,000 deposit in a savings account earning a 5.00% APY.
With an account that compounds interest daily, for example, you’ll earn $513 at the end of one year, assuming the interest rates remain constant and you don’t add to or withdraw any money from the account.
During a small window of time, the frequency at which interest compounds may seem somewhat insignificant. Keep in mind that the power of compounding interest is best realized over several years.
How is an APY different from an APR?
Annual percentage rate, or APR, is the annual rate that’s charged for borrowing money, such as when you take out a loan, use a credit card or establish a line of credit. The lower the APR, the less it costs you to borrow.
Annual percentage yield, or APY, on the other hand is used by deposit accounts, such as CDs, savings and money market accounts, to indicate how much money you can earn in an account each year. APY factors in the compounding of interest and the number of times it compounds in a year.
While APR reflects the amount of interest you pay when you borrow money, APY reflects how much interest you’ll earn when you save money.
How is an APY different from an interest rate?
Interest rates are based on a handful of factors, such as the borrower’s ability to pay back the loan, the purpose of the loan and economic factors such as inflation. While interest rates measure how much interest you’ll accrue on a loan, APY reflects the interest you’ll earn for depositing money into a deposit account, such as a CD, savings or money market account.
How do I find the best APY?
What makes for a “good” APY depends on the specific account and economic conditions. A good APY for a five-year CD, for example, will be different from a savings account, and that can change considerably from year to year. Online banks often provide higher APYs than traditional banks for deposit accounts because they have less overhead, which allows them to pass along some of these savings to their customers.
Can I change my account’s APY?
No, you can’t. Banks and financial institutions establish the interest rates and yields attached to their products and services. But you can do some comparison shopping, choose accounts that offer higher APYs and move your money into them.
The bottom line
An APY is the rate of return that’s earned over the period of one year on your investment -- such as a savings account, money market account or CD -- if the interest is compounded. The compounded interest is added to your overall investment periodically, be it weekly, monthly or quarterly, and therefore increases your balance.
The APY rates on savings and money market accounts are typically variable, meaning they fluctuate in reaction to where the Federal Reserve sets interest rates. The APY on a standard CD’s rate, however, is fixed, meaning that the yield won’t fluctuate during the CD’s term.
The APY is one of the features you’ll want to consider when deciding where to park your savings. The higher the APY, the faster your money will grow.
Correction: An earlier version of this article was assisted by an AI engine and it mischaracterized some aspects of CDs and interest rates and also misstated the equation for APY. Those points were all corrected. This version has been substantially updated by a staff writer.
