What is APY?

You might be familiar with the abbreviation APY if you’ve shopped around for a checking, savings, or CD account recently. In simple terms, APY, which stands for annual percentage yield, is the number that tells you how quickly your money will grow.

In this article, we’ll cover the basics of what APY is, how it’s different from interest rate, and how understanding APY can help you maximize the earning power of your money over time.

What is annual percentage yield, or APY?  

Annual percentage yield, or APY as it’s often abbreviated, tells you how much your money will earn after one year.

For example, if you put money in a one-year CD at a 4% APY and leave the account alone, at the end of the year, your balance should be 4% larger than it started.

How is APY different from interest rate?

Many people think APY and interest rate mean the same thing. For example, they may refer to the percentage their savings account pays them each year as its “interest rate.” However, while these terms have similar meanings, there is one big difference.

Interest rate is the annualized rate your bank is paying you. On the other hand, APY takes compounding into account, or the frequency with which interest is calculated and posted to your account.

As a simplified example, let’s say you open a savings account with $1,000 that has a 4% interest rate and calculates and pays interest quarterly (four times per year). At the end of the first quarter, the bank would pay one-fourth of the annual interest rate (1%), and you’d have $1,010.

However, at the end of the second quarter, the bank would pay 1% on the slightly higher $1,010 balance, which would add $10.10 to the account, giving you $1,020.10. The next interest payment would be based on this balance, and so on. You get the idea – over time, interest is paid on the principal and all of the interest you’ve already earned.

Because most financial institutions calculate interest far more frequently than once per year, APY is almost always greater than the interest rate. In our example, while the interest rate on the account is 4%, your APY would be about 4.06% after compounding is taken into account. You don’t need to know the math – just that compounding makes your money grow faster.

Finally, it’s important to realize that APY is the actual yield you’re getting on savings or an investment annually. Because it’s the more important number when it comes to comparing one investment with another, the interest rate is often referred to as the “nominal” interest rate.

APY vs. APR

APY is often confused with APR, but these two terms are opposites of one another. Annual percentage yield, or APY, is used to describe the returns you get on money you save or invest.

On the other hand, annual percentage rate, or APR, is used to describe the cost of borrowing money. Your credit card interest rate, as well as the financing cost of a mortgage, are two examples of financial instruments whose rates are expressed as APR.

In both cases, APY and APR are designed to differentiate from interest rate to show you the true yield on savings or the true cost of borrowing money. As we’ve said, APY incorporates the principle of compounding, and APR includes other costs of borrowing money, such as an origination fee for a loan.

APY and compound interest

APY is closely related to the concept of compound interest. If you aren’t familiar, compound interest is used to describe situations such as the difference between interest rate and APY. It means that interest is periodically paid on the principal and all of the interest that has accumulated.

The difference between APY and compound interest is that APY is an annualized term. It tells you how much the interest in your bank account or investment will compound after one year. On the other hand, compound interest can be applied to multi-year periods. Albert Einstein once allegedly called compound interest the “eighth wonder of the world” because of how powerful it is.

For example, let’s say that you put $5,000 in an account with a 5% APY. Here’s how the balance could grow over time at this rate:

Now, imagine if this was an investment account like a 401(k) that produces average yields of 7%-8% or more over time. And you didn’t just put $5,000 in once – you did the same thing every year. In situations like this, the principle of compounding can be your most powerful financial weapon.

Variable vs. fixed APY

It’s worth noting that although a bank account might advertise a certain APY, there’s no guarantee it will stay that way.

Some APYs are variable, which means that they can change over time. Savings accounts are a great example of this. Just because you see a 4% APY advertised doesn’t mean it will continue to pay that much for any specific length of time.

On the other hand, some APYs are fixed. CDs are a good example, as the APY that is advertised on a CD is guaranteed for the entire term. If you put money into a five-year CD, you’ll get the same APY for five years.

Before you put your money into a certain type of bank account or investment, be sure you understand whether your APY is guaranteed, and if so, how long it’s guaranteed for.

The bottom line on APY

APY is the number you typically see when shopping around for a savings account or CD and tells you how quickly (or slowly) your money will grow. It’s a slightly different concept than interest rate and is the best apples-to-apples comparison between different banking products.