During your monthly budgeting routine, you check out one of your savings accounts and find that the interest rate pays 0.25% APY. Is that good or bad? Is your bank giving you a competitive rate? What does APY mean in terms of the money in your account?
APY is your real rate of return on a savings or deposit account and is related to your interest rate, but the two terms aren’t interchangeable. If you really want to know what’s happening to your money when you accrue interest, it’s important to understand how APY impacts your savings. Here’s your guide to what APY means so you can better control your finances.
APY Meaning
APY, or annual percentage yield, is the real rate of return earned on an investment or interest-earning account in a year, including compound interest. This means that APY accounts for your money growing as you earn interest, not just your principal balance times the interest rate.
The key element here is compound interest, which is easiest to understand when you compare it to simple interest.
- Simple interest is the interest built on the principal amount you have in your account (meaning that the rate is only applied to the amount of money you deposit).
- Compound interest is the interest earned on the principal amount plus interest earned each period on previous periods’ interest payouts. In other words, the interest earned each period gets added to the base amount for the next period’s calculation. Interest in these scenarios can be compounded daily, monthly, or even annually depending on the account.
APY is the rate of return that is earned when the interest of a savings account or investment is compounded. Because it accounts for the compounding effect, APY allows you to compare rates across different accounts more easily.
What is the Difference Between APY & APR?
APY and Annual Percentage Rate (APR) are different ways of calculating interest. APY is typically used when determining the amount of interest one earns, and APR is often the metric used when determining the interest one pays.
The main difference between calculating APY and APR is based on how each accounts for compounding interest. APR reflects the cost of borrowing without compound interest, making it suitable for straightforward loans.
APY takes compound interest into account, providing a more accurate representation of the overall yield on investments. APY is for investors seeking to gauge the actual return on their funds, especially in scenarios where interest is reinvested, to determine their expected earnings.
How Does APY Work?
The main function of APY is that it considers the interest you make on your interest, so your money will compound and grow more quickly.
For example, say that you deposit $10,000 into a high-yield savings account that offers an interest rate of 3.00%, compounded monthly. That means each month, the amount in your account will earn 1/12 of the annual 3.00%, or 0.25% monthly. After the first month, you earn $25.00 in interest ($10,000 x 0.25%), which is added to your $10,000 principal. The next month, you earn $25.06 ($10,025 x .025%). Assuming you do not make any withdrawals throughout the year, your interest payout each month will continue to get incrementally larger due to the compounded interest. By the end of the year, you will have earned $304.16 in total interest or an actual return of 3.04% APY.
APY can apply to all kinds of interest-earning accounts, including your run-of-the-mill savings, CD, money market, and even some checking accounts. Whatever the investment, the compounded interest is periodically added to the total amount and, as a result, each interest payment is bigger than the last since the baseline balance has increased. This means that the more frequently the interest is compounded, the higher the APY will be.
Also note that your APY rate is subject to change at any point for a regular savings account, often with no notice. To keep your expectations realistic, it’s always best to monitor your rates carefully. The rates a bank or credit union gives you will usually fluctuate with federal standards and economic conditions, so keep an eye out for changes to your rates based on the current market.
Other accounts, such as CDs, may have a fixed rate that stays the same based on when you signed up. Whether the interest rate is fixed or variable will depend on the kind of account you open and the terms of the bank.
How is APY Calculated?
APY is calculated based on a couple of assumptions to standardize the rates of return, such as the money you’ve deposited will be there for one full year. This way, APY can state the real percentage of growth that will be earned from compound interest.
APY also assumes that the interest rate stays the same throughout the year. Actual rates may vary depending on the Federal Reserve or other factors, in which case you would see the APY for your account change
Annual Percentage Yield (APY) Formula
The annual percentage yield (APY) formula uses the annual interest rate and the number of compounding periods to get the APY percentage. The actual formula looks like the following equation:
- r = nominal or simple annual interest rate
- n = number of times compounded
Here’s an example. Let’s say your interest rate is 0.02 (or 2%), and your money is compounded 12 times a year (monthly). Your formula would look like this:
So, with an interest rate of 2% and monthly compounding, your APY would be approximately 2.02%.
Essentially, the higher the interest rate, the greater your APY will be, which means your money will compound faster. Plus, the more frequently the money in your account is compounded, the higher your APY will be and the more money you’ll save each year. When you are trying to set up your savings account or other types of investment, look at the interest rate and the frequency of compounding to get an idea of how quickly your money will grow.
What is a Good APY Rate?
According to the FDIC, the average APY savings rate in the U.S. is 0.46% (as of 4/15/24), but a more competitive high-yield rate would be around 2.00% or higher. This doesn’t mean a lower APY is strictly bad, as there might be other conveniences and benefits to the account (for example, having a deposit account at the same bank where your mortgage is). You just won’t see the same earnings you might potentially achieve otherwise.
If you really want to boost your savings, consider using a high-yield savings account, which has competitive APY rates more consistently throughout the year. These are also often low-cost or free accounts, so this route is typically how you can get the biggest bang for your buck.
The best way to get competitive APY rates is to go through the right bank that will help you make the most of your money, and online banks are some of the most competitive options on the market.
TAB Bank offers great rates for high-yield savings accounts and rewards checking accounts, plus other deposit options like money market accounts and CDs for your business. You can use TAB Bank for your personal finances or to gain the support your business needs to develop. Whatever your goals are, we can help you better save and utilize your money.
If you want to find out what your APY is, calculate it now using our resources, or open a new account today to start earning even more!
