It’s easy to confuse annual percentage yield (APY) with interest rates when opening a bank account. These rates serve a similar purpose of growing an amount of money over time, but there’s a few important differences.
What is an Interest Rate?
An interest rate is the base amount a deposit can earn in one year. For example, if you deposit $100 into a savings account with 3% interest, you’ll have $103 after one year.
For deposit accounts, you’ll earn interest. However, in relation to debt, interest rates are referred to as an APR, or annual percentage rate. Credit cards and loans have an APR that will increase your amount owed if you don’t pay on time.
What is an APY?
APY, or annual percentage yield is a more accurate representation of what your investment will actually earn over the course of a year. APY uses compounding interest, and is usually calculated and paid monthly. This rate is slightly higher than the base interest rate. For example, an account may have an interest rate of 3%, with an APY of 3.04%. At this APY, a $100 deposit compounded monthly would grow to $103.04 in one year.
APYs apply to deposit accounts, including certificates of deposit, money markets, savings accounts, and some checking accounts. When choosing an account and comparing rates, the higher APY is usually better. However, rates can be fixed or variable, meaning it can stay constant or change throughout your account’s term. When choosing an account, find out if the account’s APY is fixed or variable.
The formula to calculate APY is (1 + r/n)n – 1. Luckily, there are online calculators for APY and compounding interest if you don’t feel like working through the formula.
Key Differences
The main difference to remember is that an APY compounds, while an interest rate does not. Additionally, think of an APY as gaining, and an APR as owing.
Why It Matters
It’s important to know the APY of an account before opening one, so you can choose one with the best yield. It’s also important to know the interest rate of a loan or a credit card, so you can assess your risk. Understanding each term allows you to choose a product that is best for you, and helps you plan ahead.
