When you open an account at a bank or credit union, you’ll likely come across the term APY, which is short for annual percentage yield. The APY tells you how much the account will earn in interest in one year.
Different interest-earning accounts — high-yield savings accounts, traditional savings accounts, money markets, certificates of deposit, and checking accounts — all have an APY. The higher the number, the more interest the account will earn.
What does APY mean?
APY is the actual rate of return earned on your account, including compound interest. Compound interest is the interest you earn on the money you deposit and the interest you earn on that money. Sometimes people refer to an account’s interest rate, but that’s different from APY. The interest rate only considers simple interest — or interest earned on the principal in the account.
Your savings grow as you earn interest on the money in an account. The more the account grows, the more interest you earn, creating a virtuous circle of increased savings. For instance, adding $1,000 to an account with a 1% APY would earn $10 in interest in one year. After the second year, even if you didn’t add another dollar to the account, you would earn 10 cents more because your account balance grew to $1,010 from the interest you earned the previous year.
APY also reflects how often the interest compounds or is calculated and added to the account. Most savings accounts and CDs compound daily or monthly. The more often interest compounds, the faster your money will grow, although the difference is usually small unless the account has a very large balance.
How to calculate APY
Calculating APY can be helpful when you compare accounts with different APYs or compounding schedules. Typically, you won’t need to calculate the APY — the bank or credit union will do it for you.
The formula for APY is:
APY = (1 + r/n)^n – 1
r = interest rate
n = number of compound periods in one year. If your account compounds monthly, n=12.
If the interest rate of your account is 2%, which would be represented as .02, and it compounds monthly, the formula would look like this:
APY = (1 + .02/12)^12 – 1
Once you multiply the result by 100 to get a percent, your APY would equal 2%. If you’d rather not do the math, you can use a compound interest calculator to determine how your money would grow over time.
APY vs. APR
The main difference between APY and APR, which stands for annual percentage rate, is that APY is how much interest an account will earn in a year, while APR is how much it will cost you to repay money you’ve borrowed.
Let’s say you take out a car loan: The APR equals your yearly cost — including interest and fees — to repay the loan. With a credit card, the APR doesn’t include fees but tells you how much interest you’ll be charged if you don’t pay off the balance in full.
A higher APY is better because you’ll earn more interest on the money you save. A lower APR is better because it will be cheaper to repay the borrowed money.
Fixed vs. variable APY
Whether your APY is fixed, meaning it doesn’t change, or variable — fluctuates based on the economy and the bank’s policies — depends on the type of account you opened. Many savings accounts, for example, have a variable APY, while the APY on most CDs is fixed.
What is a good APY?
A good starting point to compare APYs is the national average savings rate of about 0.4%. That doesn’t mean you should settle for that rate. Many online banks offer high-yield savings accounts and CDs with APYs that are 10 or more times higher.
Online banks and credit unions typically offer much higher APYs than large, brick-and-mortar banks because it’s less expensive for them to run their operations. Just be sure the account meets your needs for how you like to bank, such as having ATM access or 24/7 customer service. Beyond that, the best account for growing your money is one with a high APY and low fees.
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