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When researching savings accounts, you’ll likely come across two key figures: Annual percentage yield (APY) and interest rate. While they may seem similar, understanding their nuances is important for calculating and maximizing your financial returns.
Here’s a breakdown of the two numbers, how they differ and why it matters when you’re finding the right bank account.
What is APY?
The APY provides a comprehensive look at your potential earnings over a year, accounting for the effects of compounding. With compounding, the interest you earn is added to your balance, and future interest calculations are based on this larger amount. The APY reflects this cumulative effect, making it a transparent indicator of your total return potential.
In this formula, “r” represents the stated annual interest rate, while “n” represents the number of times compounded.
Bankrate’s APY calculator can help you determine the return your money will earn when you input your starting balance as well as a monthly contribution amount, the account’s advertised APY and a timeframe.
What is the interest rate?
The interest rate is the base rate at which your deposit earns money. It’s a simple, straightforward percentage that doesn’t account for compounding. If you deposit $1,000 with an interest rate of 1 percent, you’d earn $10 in a year.
Interest rates can be further classified into simple and compound interest. Simple interest applies the same rate consistently over time, based on the initial amount. Compound interest, however, applies the rate to the initial amount, plus the interest that has already been added.
Essentially, simple and compound refer to how the interest rate is applied to your money. The rate could be the same for both cases, but if it’s simple, then it’ll only earn interest on the initial deposit (i.e., the principal). If it’s compound, then it will earn interest on the principal plus any earnings added to the initial balance.
What is the difference between APY and interest rate?
While both APY and the interest rate indicate how much you can earn from a savings account or investment, they do so in different ways.
APY takes into account the effects of compounding, while the interest rate doesn’t. The APY, then, is the effective rate of return for an account that earns compound interest. As a result, APY is typically higher than the interest rate when compounded more than once a year.
|Includes the effects of compounding||Doesn’t include the effects of compounding|
|Better for an apples-to-apples comparison between bank accounts/bank products||Gives a limited picture of actual earnings|
APY vs. interest rate example
To illustrate how APY and interest rate differ, consider this example:Suppose you deposit $1,000 into a savings account with an interest rate of 5 percent. If this were a simple interest rate, you would just earn 5 percent of $1,000 after a year, which amounts to $50 earned. However, most savings accounts compound multiple times within a year, so let’s say the 5 percent interest rate compounds monthly. After a year, you’d have $1,051.16.
If you calculate APY using the earlier formula, it comes out to be about 5.116 percent. Considering the effects of compounding, your $1,000 deposit is effectively growing at a rate of 5.12 percent (rounded to the nearest hundredth) annually, not the simple 5 percent interest rate.
If you’re looking at one bank account that offers a 5 percent interest rate and another that offers a 5 percent APY, the account with the 5 percent interest rate may actually earn more if it’s compounded.
While this difference might seem small, it becomes more pronounced as you deposit more money and as the money is invested for longer periods of time. (Banks are required to list the APY for their deposit products.)
Here’s a chart that compares how $1,000 would grow over time for an account that earns 5 percent simple interest and one that earns 5.12 percent APY:
|5 percent simple interest rate||5.12 percent APY (a 5 percent interest rate compounded monthly)|
|Interest earned after 1 year||$50||$51.20|
|Interest earned after 5 years||$250||$283.59|
What to know when shopping for savings accounts
When comparing savings accounts, look at the APY, also referred to as annualized percentage yield, rather than the interest rate, as it gives a more accurate picture of your potential earnings over a year by factoring in compounding.
High-yield savings accounts are a great option for those looking to get the highest possible earnings. Some of the top-yielding accounts are offering APYs of over 5 percent, as of this writing, while some traditional savings accounts at the largest banks are still only earning 0.01 percent APY. Note that many of the highest-yielding accounts are at online-only banks.
Remember, too, that a good savings account does more than just provide a high APY. Look out for various bank fees, such as monthly maintenance fees and overdraft fees, as these can eat into earnings and even potentially cancel out the APY, if you’re earning less than what you’re paying in fees. Also compare digital features and customer service options.
While high-yield savings accounts are a great choice for short-term savings goals and storing an emergency fund, you may also want to consider certificates of deposit (CDs) for longer-term goals. Some CDs may offer a higher yield than a savings account, and if you lock in at a high rate now, the CD will continue to earn that rate until it matures — unlike a savings account, which comes with a variable rate. However, early withdrawals from CDs often come with penalties.
When it comes to CDs, the bank will list an interest rate as well as an APY, like with other deposit products. Paying attention to a CD’s interest rate can be relevant in the event the interest is paid out at intervals prior to maturity. For instance, Capital One allows CD holders to decide whether the interest is paid out monthly, annually or at the end of the term.
A bank account’s APY incorporates the effect of compounding interest. This means you earn interest on the accumulated interest, rather than just on the money you deposited into the account. Looking at an account’s advertised APY, rather than just its interest rate, can give you a more accurate picture of how much your money will earn over time.
Because not all savings accounts are created equally, shopping around for one with a competitive yield is a good idea, as well as looking for accounts with no monthly fees and no minimum balance requirements.