APY vs. Interest Rate

Interest rates project earnings, but the APY displays your true yield and return.

Interest rates project earnings, but the APY displays your true yield and return.

"APY" is the abbreviation for "annual percentage yield" and applies to savings accounts. The APY involves a combination of the interest rate paid on the account and the number of interest-earned postings. Your savings account's interest rate is the dominating factor, but your APY will be higher than your stated interest rate. Even if you have an active account, with consistent additions and withdrawals, your APY will exceed your interest rate, at least marginally.

Interest Rate

Your bank or credit union publicizes a stated interest rate for all savings accounts. Except for certificates of deposit, for which the rates are usually fixed for the term of the account -- three months, six months, one year, two years or longer -- savings interest rates can change as often as the bank feels necessary. These changes will, of course, affect your APY over the course of a year.

Savings Accounts Involved

All savings accounts, regardless of terms, will have an APY.The most popular accounts are regular savings, permitting unlimited deposits and withdrawals; money market accounts, or MMAs, with deposit and withdrawal restrictions; and certificates of deposit, or CDs, which often prohibit any additions or withdrawals during the time period of the certificate. The calculations are more complex for those accounts with many transactions, widely fluctuating balances and a number of interest postings during the year. For example, calculating the APY for a six-month CD with one interest posting at the end of its term is much easier than calculating the APY for a family savings account with quarterly interest postings, many additions and withdrawals and multiple account rate changes during the year.

Calculating APY

Calculating an APY can be simple or challenging, depending on the type of savings account, but the formula is straightforward. APY equals (1 = r/n)n, where "r" equals the interest rate paid on the account and "n" equals the number of compounding periods -- interest postings -- during the year. Since the APY displays the wonderful effects of compounding -- earning interest on interest -- a savings account paying interest daily will have a higher APY than an account that posts interest semiannually, regardless of the amount of interest posted.

Benefits of APY vs. Interest Rate

Interest rates are important, but the APY tells you what you're really earning on your savings account. For example, you can analyze two accounts both paying 4 percent per year. But one pays interest semiannually, making your APY 4.04 percent. The other savings account pays daily interest. At the end of a year, you will have earned 4.081 percent. While the difference may not make you rich, the daily interest account is the better option.

 

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