If you’re comparing options for a new place to save money and earn interest, pay close attention to the annual percentage yield. The APY shows the real interest rate you’ll earn on a balance in one year -- and it’s likely a little higher than the interest rate.
What’s the difference between these two numbers and how is compound interest involved? Read on to learn more about APY, other types of yields and how they can help your money grow.
What is annual percentage yield and why does it matter?
The APY represents the real rate of return that you earn in 12 months from a deposit account by factoring in the effect of compound interest. Your account’s interest is compounded periodically -- daily, monthly or quarterly in most cases -- and then added back into the account. That new, larger balance now accrues interest, which is added back into the account, and so on. When choosing a savings account, high-yield savings account, certificate of deposit, money market account or interest-earning checking account, you can use the APY to find out how much you’ll earn.
How is an APY different from an interest rate?
Financial institutions advertising savings accounts will typically list the APY and the simple interest rate -- sometimes referred to as the “nominal interest rate” and generally a lower number. That’s because the interest rate is what you’ll earn on the account without factoring in compound interest.
The APY gives you a better understanding of your potential earnings because it incorporates how often interest compounds, or compound frequency. You’ll earn more if the interest compounds daily than if the interest compounds annually, for instance. The frequency at which interest compounds may seem somewhat insignificant, but keep in mind that the magic power of compound interest is best realized over several years.
Many savings accounts compound interest daily but pay it to the account monthly. Banks and credit unions all have their own policies when it comes to compounding intervals, so be sure you know the rate before opening an account.
How to calculate APY
Since banks typically list an account’s APY, you’ll rarely have to do this calculation yourself. But here’s the formula to calculate APY:
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.
As an example, if your interest rate is 5% (or 0.05 as a decimal) and interest is compounded quarterly (or 4 times/year), your APY would be:
(1 + .05/4)4 – 1 = 0.0509453369140625 or 5.09%
You can then multiply that number by the amount of your deposit to find out how much interest you’ll actually earn in a year.
So using the above example, if you had a $5,000 deposit:
$5,000 x .0509 = $254 in interest in one year
If you don’t want to do the math yourself, you can use this compound savings calculator or CD calculator from CNET’s sister site, Bankrate.
What’s the difference between a fixed and variable APY?
A fixed annual percentage yield will not change because the interest rate and the compounding periods are set. For example, if you open a three-year CD with an initial deposit of $5,000 that pays a fixed 3% APY, you’ll have $5,463.64 when the term is over.
A variable APY means the institution can change the interest rate at any time. For example, a high-yield savings account may have an APY of 5% right now, but if the Federal Reserve cuts interest rates, the bank may drop the APY to 4.5%.
When you’re comparing options, read the fine print about what type of rate is attached to the account. Banks and credit unions must disclose whether the APY is variable or fixed along with their rates.
How is annual percentage yield different from annual percentage rate?
An annual percentage rate, or APR, indicates the amount of interest you pay when you borrow money. It’s basically the opposite of APY, which indicates how much you’ll earn when you save money.
APR is based on a loan’s compounding interest rate, but it may also include additional costs, like fees and closing costs if it’s a mortgage or loan.
Your credit card APR is the rate you pay to carry a balance from month to month. It includes the amount of interest and other fees you’ll pay for your credit card over the course of an entire year, but it actually accrues at a daily rate.
Generally speaking, you want a lower APR to limit your borrowing costs and a higher APY to maximize your savings.
How do I find the best APY?
What makes for a “good” APY is relative, as rates can rise and fall depending on economic conditions, including the Fed’s decision to hold or change interest rates. So if the Fed ends up lowering interest rates, next year’s “good” APY for a savings account could look anemic compared to the APY you might earn now.
Finding the best APR can also depend on a number of factors, including:
- How much money you’re depositing
- How long you want to keep the money in an account
- How much liquidity you need (meaning, whether you need to be able to access the money quickly)
Financial institutions tend to offer higher rates for accounts that require larger balances and lock up funds for longer periods of time. However, it’s important to understand that a longer term isn’t always better. Due to uncertainty about where rates may be headed next, rates on some 1-year CDs have been outperforming rates on 5-year CDs recently.
If you’re chasing the best rates on an account that still lets you access your money quickly, high-yield savings accounts tend to pay considerably higher rates than standard savings accounts.
Can I change my account’s APY?
Banks and financial institutions establish the interest rates and yields attached to their products and services. And while you can’t do anything to negotiate a higher APY, your bank or credit union may adjust it, depending on your account type.
For savings accounts and money market market accounts with variable APY, interest rates may change depending on economic conditions and changes to the Federal Funds Effective Rate.
And if you’re unhappy with the APY you’re earning on a traditional savings account, consider switching to a high-yield savings account that offers a higher rate.
The bottom line
When you’re looking at new account options for your money, it’s easy to focus on fees and minimum balance requirements. However, the annual percentage yield is an important factor that will impact how much money you can earn. Regardless of what type of account you’re opening, do some comparison shopping to score the highest possible return. The higher the APY, the faster your money will grow.
FAQs
It’s important to understand “good” is relative. FDIC data shows that the national rate on savings accounts was 0.47% in March, while 1-year CD rates averaged 1.81%. There’s no need to settle, though. Expand your search to online-only banks and credit unions to find the best APY for high-yield savings accounts and CDs, which are currently at or near the 5% range.
The Truth In Savings Act mandates that banks must disclose the interest rate, how often interest compounds and when it is credited to your account. Reach out to the bank or check the disclosures before opening an account.
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.
