APY vs. interest rate: What's the difference?
Quick insights
- Interest rate refers to the base percentage of earnings on your savings or loan.
- Annual percentage yield (APY) is the total interest you earn from an account in one year, including compound interest.
- APY often provides a more accurate picture of how much money a savings account earns in one year.
If you’re thinking about opening a savings account, one key factor to consider is how much interest the account may earn. As you compare savings accounts, it may be helpful to review the interest rate and the APY for each.
While APY and interest rate both relate to how your money grows in growth and savings products, they have key differences that may affect your financial decisions. Understanding these differences is important to making choices about where to deposit your savings.
What is an interest rate?
An interest rate is the percentage that shows how much interest you'll earn on your deposit or pay on a loan over a period of time, usually expressed annually. For example, if you have a savings account with a 3% interest rate, you’ll earn 3% of your account balance each year. If you have a $1,000 balance with a 3% interest rate, after one year, your account balance would be $1,030.
However, the interest rate typically doesn’t account for compounding, which can be crucial when it comes to understanding your earnings in savings accounts. Put simply, compounding is the interest you may earn on interest over time. Meaning the $30 in interest you earned on your $1,000 balance also earns interest, which is then added to your balance if the account has compounding.
So, while the interest rate may give you an idea of your yearly returns, it generally doesn't show when interest is added, or compounded, to your balance.
What is an annual percentage yield (APY)?
APY represents the total interest earned over the course of one year, factoring in compound interest. Interest on savings accounts may be compounded at various frequencies: daily, monthly, quarterly or annually. A higher frequency of compounding (e.g., daily or monthly) typically means more frequent additions to your balance, which generally results in more interest earned.
How to calculate APY
Let’s use a similar example to the above: You have a $1,000 savings account balance with a 3% interest rate. But this account earns compound interest, and the compound frequency is monthly.
- A $1,000 balance with a 3% interest rate earns $30 per year.
- Since the compound frequency is monthly, divide $30 by 365 days to get the daily interest rate, which is approximately $0.08219. Multiply this by the number of days in the cycle (e.g., 30 days), which is approximately $2.47. Your total bank balance after 1 month is $1,002.47.
- Then, the next month, the bank calculates interest on the new total, $1,002.47. The daily interest rate is approximately $0.08219. Multiply this by the number of days in the cycle (e.g., 31 days), which is approximately $2.55.
- So, after the second month, the bank would deposit $2.55, bringing your new account balance to $1005.02.
- Your account will continue to accrue interest in this way each month. Assuming you don’t withdraw or deposit any additional funds into the account and the interest rate stays the same, after 1 year, your account balance would be $1,030.42.
Why APY matters for savings
When you’re choosing a savings account, APY is typically the more important figure to consider because it reflects the true annual growth of your account. Be sure to compare the compound frequency as you search for the best savings account for your needs, since that may significantly impact your earned interest over time, whether starting small or opening an account with a large deposit.
For instance, if two savings accounts offer the same interest rate but one compounds interest monthly and the other annually, the account with monthly compounding will generally offer a higher APY. This means that you could earn more on your deposit over time with monthly compounding.
In summary
When choosing a savings account, APY is the most important figure to focus on because it typically gives you a clearer picture of your savings after a year of earning compound interest. While the interest rate may tell you roughly how much you’ll earn in a year, APY incorporates the effect of compounding, which means it generally provides a more accurate picture than just the base interest rate.
By understanding the difference between APY and interest rates, you can make more informed decisions about which financial products will help you achieve your savings goals. Whether you’re looking to open a savings account or a certificate of deposit (CD), APY will generally give you a more accurate sense of potential earnings.
