If you’ve been looking at opening a new bank account, then you’ve probably come across the term APY.
It’s often something that you’ll see in many account types, from traditional savings accounts and Certificates of Deposit accounts, to even checking accounts.
Many people use the terms APR and APY interchangeably, but understanding how APY works is important when comparing accounts and banking products.
In this article, we’ll look at everything there is to know about APY, including how to calculate it for yourself.
What is APY (Annual Percentage Yield)?
Annual Percentage Yield, also known as APY, tells you how much interest money you’ll earn on your principal investment. APYs are always represented as a percentage – this is the percentage of the capital money that will be returned in one year.
Additionally, the APY rate considers what is known as the compounding effect. Compounding refers to the idea that your interest can also earn interest.
For example, you have an initial sum of $100. You earn $10 in interest. During the next compounding period, even with the same principal and rate, you earn $11.
Over time, this becomes increasingly powerful, eclipsing your initial investment. APY factors this “extra” return on your principal into the rate you see advertised. Whereas APR, on the other hand, is the simple 10%.
Whether you’re investing or borrowing money, these rates apply on everything from savings accounts to CDs and credit cards.
APR vs. APY
As we mentioned, APY considers the compounding effect while APR is the flat simple interest rate. The more frequently the interest compounds (daily vs monthly, for example), the greater the difference between APR and APY.
Technically, if there’s interest being earned or paid, there’s an associated APY and APR. Which one you’ll see advertised, however, comes down to marketing.
Financial institutions will tout credit products using APR (because it’s the smaller number) while advertising APY for their interest-bearing products (because it’s the larger number). Don’t be fooled!
How does APY work?
Calculating APY is based on a standard formula, but this formula uses terms that vary from one bank to the next, or even between accounts at the same institution.
Some inputs are in your control, such as how much money you’ll deposit or borrow (with the exception of minimum deposit requirements). Other inputs, such as the compounding frequency and annual rate, are set by the bank.
In this section, we will be looking at each of these variables in order to help you choose the account with the most beneficial APY for you.
Because everyone’s financial situations and requirements are different, it’s important to understand what you’re looking for first and then find the best option.
The Interest Rate
The interest rate is always expressed as a percentage. As we stated earlier, this is the percentage of the capital sum – the amount of money you deposit or borrow.
When depositing money, it represents what you will earn. When borrowing money, it means what you will owe the lender.
A standard rate is an interest rate that remains the same regardless of the amount of money deposited or borrowed and irrespective of how long. These can be the easiest rates to work out as it is one flat rate across the board.
Keep in mind that standard rates can change. Some accounts lock in the rate while others offer a variable rate.
Fixed vs. Variable Rates
While both fixed and variable rates are based on the rates issued by the federal reserve, variable rates can change even daily, depending on the product’s terms and the rate issued by the government that day.
Variable rates make it harder to plan. The rate can go up or down. This is why high-yield savings accounts have interest rates that fluctuate. Over the past year, the average interest rates for HYSA have decreased from 1.5% to 0.40%.
Fixed or locked-in rates remain the same for the duration of the account. Here, you might miss out on a higher percentage should this rate go up, but it will also help you avoid a lower rate of return should this go down.
In some cases, rates are tiered. This means that the rate is tied to variables such as the capital sum and/or the duration of the account.
This is most commonly seen in CD rates. The more money you deposit or the longer the term you choose, the more interest the bank is willing to pay.
Here it’s important to understand what the conditions are and plan accordingly. Doing this will help you know how much money you will earn or pay – depending on the type of account to which the rate is tied. Just like standard rates, tiered rates can also be locked-in or variable.
The Compounding Frequency
The compounding frequency is what makes APYs so unique and, as such, should be looked at very carefully. The compounding frequency is how often your interest payment (to or from you) is calculated. The more frequently the interest compounds, the higher the APY rate and the more money you’ll make or pay by the end of the year.
In most cases, the compounding frequency will be daily, weekly, monthly, quarterly, or yearly.
Example of Compounding Interest
To better understand the impact of compounding and its effect on the APY rate, let’s look at an example.
Let’s say you open a savings account with an initial deposit of $1,000. The account advertises an APR of 10% and compounds daily.
The APR of 10% would suggest you only make $100 by the end of the year. But, because of compounding, you actually make $105.16. The APY is then 10.516%.
As a quick comparison, if the same investment was compounded monthly instead of daily, the APY would be 10.471%, and you would have earned $104.71.
Similarly, if the above example only compounds annually, then the APY would be the same as the APR: 10%. In real-life terms, you’ll see this with a fixed-rate mortgage or a typical car loan. Because interest charges aren’t added to your loan balance, there is essentially no compounding effect.
The Pay Frequency
The final piece to understanding all of the implications of a bank’s advertised terms is the pay frequency. The pay frequency is how often you’ll receive the compounded interest in your account. Keep in mind this can be longer than the compounding frequency. For example, an account may compound daily but only actually payout weekly.
In most cases, you can expect the pay frequency to be monthly, but it may vary.
How to calculate APY
When it comes to personal finance, planning is essential, and not only because it allows you to avoid situations where you don’t have enough money to cover expenses. Financial planning gives you the insight you need to grow your money – and that’s what truly matters if you want to become financially independent.
Knowing how to work out the APY yourself can help you understand exactly how much money you will be able to make.
Method 1: Do The Math
If you’re interested in calculating APY with pen and paper, the formula is:
(1 + r / n) ^ n – 1
where r = stated interest rate and n = number of compounding periods each year
Taking the example from earlier, where you have an account that offers an APR of 10% and compounds daily, the formula would be:
( 1 + .10/365 ) ^ 365 – 1
APY = 10.516%
Using this formula, we will know exactly the APY rate that the account or product will return – as long as we know the rate on offer and the frequency at which it is compounded. Most banks and credit unions will publish this information on their website and make it relatively easy to find.
Method 2: Let Calculators or Excel Do The Math
You can also use an online compounding calculator. Even most banks offer them on their website or mobile banking app.
To use these calculators, you will need to enter the following information:
- Principal. Your initial deposit.
- Interest rate. The flat simple interest rate (APR).
- Duration. How long you’ll leave the money in the account.
- Compound interval. The frequency at which the interest compounds.
- Monthly deposits. How much more money will you transfer into the account every month, if applicable. You can set this as 0 if you’ll only make your initial deposit, a positive number if you’ll be contributing to the account, or a negative number if you’re withdrawing some each month.
You can also use Microsoft Excel, Apple Numbers, or Google Sheets to work out the APY, if that’s more your thing.
Regardless of which method you choose, knowing how to work out the APY rate will keep you from being blinded by flashy wording. It makes it easier to compare different products by revealing the APY and total interest earned from one account versus another, which you can then easily use to determine which is most favorable.
For example, if you’re looking to invest for 3 years in products that are offering either 9.5% compounding daily, 10% compounding monthly, or 10.25% compounding just once a year.. which do you go with?
That’s tough if you don’t understand the principles of APY. But after reading this article, you’ll know that the bank offering 10% compounding monthly nets you the biggest return.
One word of caution here: all of the above methods assume a fixed rate. If the product you’re looking at is variable, then you can make an educated guess with an estimated rate, but know that the actual returns will be based on the rates set by the Federal Reserve.
Which bank accounts offer APY?
Many banks have been facing increasing competition and have started to offer an APY on accounts that traditionally did not earn depositors any interest.
Many FDIC-insured deposit accounts such as Savings and CDs offer interest. You can expect to find the highest APYs from these, particularly if it’s coming from an online bank or credit union. Some banks have also started to offer interest on your checking account balance. However, you can expect to get lower rates with checking accounts, usually in the decimal point range.
But also keep in mind that credit products like credit cards will advertise an APR. But if you don’t pay them off completely each month, there’s a compounding effect that means in real terms, you’ll be paying more in interest than that advertised APR. You now understand that this is the APY.
Frequently Asked Questions
Is APY paid monthly?
While there is nothing that states that APY has to be paid monthly, in most cases, it is. Banks and credit unions will typically inform you of the payment frequency in advance.
Keep in mind that the payment frequency can be different from the compounding frequency and that the latter is the one that directly affects how much interest you’ll ultimately earn.
What is APY vs. APR?
Both APY and APR (Annual Percentage Rate) are ways of calculating interest over time. To do this, both of them use a percentage, which needs to be applied to the capital sum, applicable over one year.
APY differs from APR in that it also considers what is known as the compounding effect. Compounding interest is the principle where your previously earned interest also earns interest.
If your interest only compounds annually, then APY and APR will be the same. But if the account offers a compounding frequency greater than 1, then the APY will be higher than the APR. This is great in interest-earning products – not so great in borrow products like loans or credit cards.
What is a good APY?
A good APY will largely depend on the type of account you’re looking to open. While most checking accounts do not have APY, some of them do. Even so, this rate will be nowhere near as high as a High-Yield Savings Account or a long-term CD. Here, you’ll find higher APY rates that go up to 1.40% or higher.
What is APY on a credit card?
Several credit card providers advertise APR, but if you carry a balance from month to month, the interest is compounded (usually daily). In this case, the interest rate is divided by the number of days in a year to give the percentage that needs to be applied to the account balance every day.
In practical terms, this means that you’ll be paying more in interest than the simple APR would have you believe because you’ll be paying interest not only on your purchases but also the interest on those purchases.