Editor’s Note: We earn a commission from affiliate links on Forbes Advisor. Commissions do not affect the opinions or ratings of our editors.
When Opening a bank account, there are a number of factors to consider, including the APY. APY is short for Annual Percentage Return and is a way of measuring how much your money can grow over time as you earn interest on your deposits.
APY is often confused with APR, which is also a measure of interest rates. However, the two mean very different things. If you are planning to open a bank account, it is helpful to learn more about APY and how it works.
What is APY?
Percentage annual return is a way of measuring the amount of money made in an interest-bearing account, annualized over the course of a year. In other words, this is a way of measuring how interest rates add up over time.
Compound Interest is the interest you earn on your interest. It means interest paid on both the principal (i.e. your deposits into the account) and the interest you earn. That’s what makes it such a powerful tool for investing, since compounding can make it possible to build wealth over the long term. This differs from simple interest: Simple interest represents interest earned on the principal deposit only.
Interest can accrue over different periods of time. For example, it can be compounded daily, monthly, quarterly or annually. In the case of APY, compounding occurs over a period of one year.
APY vs interest rate
ONE saving account or another interest-bearing account may have both an interest rate and an APY. But they mean different things when they save money.
The interest rate is the interest rate earned on an account. For example, your bank pays you an interest rate of 0.40% on your savings account. The interest rate and APY on a deposit account can be the same or different depending on how the bank sets them.
The interest rate itself does not take into account the effects of compounding. On the other hand, APY represents the total amount of interest you could earn by compounding interest over a period of one year.
How APY is calculated
The percentage annual yield can be determined using a specific formula. This formula is as follows:
APY = (1 + r/n)n + 1
In this formula, r equals the interest rate you earn on a deposit account, while n equals the number of periods over which interest is accrued. You can do these calculations using a spreadsheet, although the easiest way to run the numbers is to use an APY calculator.
You can also use a compound interest calculator to estimate how much your money could grow over time. To use a simple compound interest calculator, you need to know the following:
- The initial deposit for the account
- How much you want to deposit each month
- The APY and compounding frequency for the account
- How long you want to save and allow interest
Here is an example. Suppose you want to open an online savings account with an initial deposit of $1,000. They plan to deposit an additional $100 per month into the account. Your chosen bank offers an APY of 0.50% and the interest is compounded daily.
If you made your monthly deposits as planned, after one year you would have $2,208.01. This equates to $1,000 for your first deposit, $1,200 for additional deposits, and $8.01 for interest earned. If you continued your monthly savings habit and compounded your money over 20 years, you would end up with $26,346.01.
What APY means for bank accounts
Various types of bank accounts can earn interest and be assigned an APY, including:
- Interest-bearing checking accounts
- Traditional savings accounts
- High Yield Savings Accounts
- money market accounts
- Certificates of Deposit
The APY you can earn for each type of account can vary widely depending on whether your account is with a brick-and-mortar bank, an online bank, or credit union. In terms of what the APY means to you, it can tell you at a glance how much your money could grow over the course of a year.
In general, the higher the APY for an interest-bearing account, the more opportunities your money has to grow. Therefore, APY is an important consideration, in addition to feesMinimum deposit requirements and other considerations when choosing a new savings account, call money account or other interest-bearing account.
It is also important to remember that APY is usually variable. This means that the APY you earn on a deposit account can go up or down over time. This is because banks tie the interest rates and APYs offered on deposit accounts to an underlying benchmark rate such as the Federal Funds Rate. If the Federal Reserve lowers the federal funds rate, Banks typically follow suit, lowering interest rates and APYs on savings accounts. On the other hand, if the Fed hikes rates, banks can do the same to savings and other deposit accounts.
Certificate of Deposit Accounts can be the exception to this rule. A CD account is a fixed deposit, meaning you agree to hold your money in the account for a set period of time. In return, you earn a fixed rate instead of a floating rate until the CD matures. Some banks offer Raise Your Rate CDs or Bump Up CDswhich allow you to increase your rate and APY during your CD runtime, although this is not the norm for normal CD accounts.
APY vs. APR (annual percentage)
APY and APR may sound the same, but they are not identical. When you talk about APY, talk about how much interest you could earn in a bank account. When you talk about APR or APR, you are talking about how much interest you pay to borrow money.
For example, if you have a credit card, student loans, mortgage loan, car loan or any other loan, your lender assigns a specific APR to your account. This APR represents the annualized interest on the debt when the interest rate and fees are factored in. Fees that may affect the APR may include lending fees, prepayment penalties, or other costs you may pay to the lender.
The APR can be fixed or variable depending on the type of loan. ONE mortgage loan, for example, may have a variable interest rate, although fixed rate loans are more common. With credit cards, the effective annual rate is usually variable. And again, similar to an APY, a variable APR can fluctuate up or down as the underlying reference interest rate changes. In case of credit cardsThis benchmark is usually the prime rate, which is the interest rate that banks and lenders offer their most creditworthy customers.
With APY, a higher yield is better, but with APR, it’s the other way around. The higher the APR on a loan or line of credit, the more interest you pay on it. The APR you pay to borrow money is usually linked to your creditworthiness. The better your credit score, the more likely you are to qualify for a lower APR and vice versa. However, your credit rating does not affect the APY you would earn from a savings account money market account.
How to find the best APY
Getting the best possible APY on a deposit account is something to consider if you want to prioritize growing your savings over time. To find the best APY, you need to do a little research beforehand to compare different banks and bank accounts.
online banks, for example, savers can offer higher APYs – compared to traditional banks – because they tend to have lower overheads. Credit unions can also offer competitive APYs to their members.
There are a few things to consider when comparing APYs, including:
- What type of account you earn interest on
- Like this account fits your needs in terms of accessibility, features, etc.
- Whether the APY is flat or stepped
Banks can offer a single APY on a savings account, money market account, or CD, regardless of account balance. So you can earn the same APY with a $1,000 balance as someone with $100,000 in their account.
But banks can also grade interest rates and APYs to reward those with more money in savings with a higher interest rate. In this case, you can earn an APY for balances up to $10,000, a higher APY for balances up to $25,000, and another higher APY for balances up to $100,000. When interest rates are low, other banks can use the opposite strategy, so to speak, to hedge their bets, paying a higher APY for savings up to $10,000 and a lower APY for balances greater than $10,000.
This is sometimes called compound annual interest, and it’s worth paying attention to how banks structure the interest they pay to savers. At the same time, consider what compromises you may make when it comes to fees. If you earn a higher APY but are expected to pay a high monthly maintenance fee to keep your savings account open, it could wipe out any interest you earn.
Introductory APYs are another thing to be aware of. To attract new customers, banks can offer a higher promotional APY in the first year your account is opened and then reduce it to a lower APY thereafter. When you come across a savings account with an attractive APY, it is important to consider whether that rate is ongoing or temporary.
Understanding the percentage annual return, or APY, is critical to getting the most out of your savings accounts. Also, consider whether APR is calculated daily, monthly, quarterly, or annually, as the differences can add up over time. When interest rates are generally low, you may feel like you’re not making any money with your savings. however even when interest rates are lowthere may be measurable differences in the APYs offered.