APY is an abbreviation for “annual percentage yield,” which is the percentage that indicates how much interest a bank account, such as a certificate of deposit (CD) or a high-yield savings account, earns in one year. The higher the APY, the more you earn. Unlike a simple interest rate, however, APY factors in compounding.
Here’s all that you need to know about the meaning of APY and how to know how much your account is paying you.
What does APY mean?
APY is a key feature to consider when shopping for a place to stash your savings. Some checking accounts also pay interest, too, although not much.
An APY includes the effect of compound interest, which is when both your principal and the accumulated interest earn interest. Compounding helps your cash grow faster than simple interest, which pays interest only on the principal.
Interest on an account can compound yearly, monthly, quarterly or daily. Accounts that compound more frequently generally earn more because the interest is computed and added to your account more often.
That’s why it’s important to consider APY — and not just the interest rate — when looking for a bank account. Comparing APYs helps you see how accounts stack up against each other.
What’s a typical APY?
Account APYs can differ dramatically, depending on the financial institution and the product. For example:
- The checking accounts with the highest yields pay up to 4.62 percent APY as of July 2024, while other checking accounts pay nominal to zero interest.
- The national average for a savings account is only 0.61 percent APY as of Jul. 29, 2024, but the best online savings accounts pay at least 5 percent APY.
- For Jul. 29, 2024, the average APY on a one-year CD is 1.8 percent, a significant increase from averages in previous years. But if you shop around, you can find one-year CDs that pay 5.26 percent APY or higher.
Your product choice can make a difference to your earnings. You can use Bankrate’s CD calculator to compare earnings.
APY formula
To calculate APY, the formula is:
APY = ( 1 + r ⁄ n ) n – 1
The “r” variable is the annual interest rate in decimal form (so 5 percent would be 0.05). The “n” variable is the number of compounding periods per year.
As an example, suppose you have a savings account with a 5 percent simple interest rate, compounded monthly (12 times in a year). You’d plug the following numbers into the formula:
Using a calculator to do the math, you get an APY of 0.0512, or 5.12 percent.
How can you find the APY for an account?
Thanks to a federal law called the Truth in Savings Act (Federal Reserve Regulation DD), financial institutions must disclose to customers the account APY and the frequency of compounding, among other details.
This information can usually be found on bank websites.
If you want to figure out how much you might earn on an account given its APY, you can use Bankrate’s savings calculator. Say, for example, you want to put $1,000 into a savings account that earns 5 percent APY, and you plan to contribute $200 a month for two years. You’ll earn $334 in interest and have a balance of $6,134 at the end of two years.
APY vs. APR: The difference between the two
While APY represents how much interest you’ll earn on an account, APR, which stands for “annual percentage rate,” represents the annual cost to borrow money.
The APR is an important consideration when shopping for home loans, personal loans, car loans or credit cards.
For example, when you buy a house, the lender might offer an appealing mortgage rate, but it’s the APR that will tell you how much the loan will actually cost because rolled into that percentage is the interest, plus any points and fees the lender might charge.
Essentially, APY and APR are opposites: APY indicates how much you earn by saving money, while APR indicates how much you pay by borrowing money.
Is APY variable?
APYs can be fixed or variable, depending on the type of account you open. For example, a typical CD account pays a fixed rate for a specific term, such as one year or five years.
But savings accounts and checking accounts pay variable APYs, which means the rate can fluctuate. The rate you get when you sign up might move up and down over time.
A key factor affecting APYs — and APRs — is what the Federal Reserve does with the federal funds rate. After hiking interest rates 11 times in 2022 and 2023 to combat inflation, the Fed has held rates steady for a year. As a result, rates on many deposit accounts and loans have remained high, overall.
Meanwhile, the Fed is widely expected to lower rates in coming months. When the Fed lowers the federal funds rate, it results in lower interest rates on many deposit accounts and loans.
While the current high rates are discouraging news for people trying to snag a low APR on a credit card or other loan, federal funds rate hikes are usually welcome news for savers because banks typically increase their APYs when the Fed raises the benchmark rate.
Bottom line
The APY on your bank or investment account tells you how much interest you will earn, factoring in the frequency of compounding. The power of compounding interest is that you’re not earning interest only on the cash you deposit; you earn interest on accumulated interest, which can grow your balance exponentially.
APY isn’t the only factor you should consider when shopping for a new account. Inquire about bank fees, such as monthly maintenance fees and administrative fees, because they can erode your earnings.
Be sure to know the APY and read the fine print on the account to understand the full cost of the product before signing up.
– Former Bankrate writers Libby Wells and René Bennett and freelance writer Taylor Medine contributed to previous versions of this article.
Read the full article here
