What Is APY?

There are several factors to consider when opening a bank account, including APY. Short for annual percentage yield, APY is a way to measure how much your money may grow over time as you earn interest on your deposits.

So, how do you calculate APY? And how do you get the highest APY on banking products?

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Here’s what you need to know about APY and how it works.

What Is APY?

Annual percentage yield is a way to measure the amount of money earned on an interest-bearing account, annualized over a year.

The higher the APY on a savings account, the more money you earn on the balance. But APY can also apply to banking products other than savings accounts, such as interest-bearing checking accounts, money market accounts and certificates of deposit (CDs). Cash management accounts, offered through online brokerages, are another option for earning an APY on deposits.

How To Calculate APY

There’s a formula to calculate APY. You’ll need to know the interest rate for the account in question to use the formula.

But why calculate APY?

Performing this calculation can help you gauge how much your money may grow over time. That’s important if you have some specific savings goals.

APY Formula

Here’s what the APY formula looks like:

APY = (1 + r/n)n + 1

In this formula, r equals the interest rate you earn on a deposit account, while n equals the number of periods over which interest compounds.

There are several ways to run these numbers, including via spreadsheet, though often the simplest way is to use an APY calculator. Keep in mind you won’t often need to calculate APY since this is information that your bank or credit union typically supplies.

Comparing APY Between Investments

Knowing the APY can help you compare different savings products.

For example, assume you have $1,000 to save. You can choose between a high-yield savings account earning 0.55% or a 12-month CD that earns 0.75%. The savings account gives you the option to make additional deposits each month; the CD doesn’t.

So, which investment is better, based on APY? The CD offers the highest APY between the two.

But keep in mind that you typically can’t add more money to a CD beyond your initial deposit. Over one year, your CD in the scenario above would earn $7.50 in interest, assuming interest is compounded daily.

Now, say you take the savings account with the slightly lower APY. But you add $100 to it each month. After one year, you’d have earned $12.03 in interest if interest is compounded daily.

Even though the CD has a higher APY, you’ll earn more interest from the high APY savings account over time if you add money to it—something to consider when comparing savings options.

Is APY Variable?

APY can be variable or fixed, depending on the type of deposit account. With a savings or money market account, the APY is usually variable. This means it’s tied to an underlying benchmark rate.

If the benchmark rate increases or decreases, your APY can follow suit. Savings account rates typically adjust in relation to what happens with the federal funds rate. If the Federal Reserve slashes interest rates, banks may reduce the APY paid to savers.

With CDs, the APY you earn is typically fixed. A CD is a time deposit account, meaning you agree to keep your money in the account for a set period. In exchange, you earn a fixed interest rate, rather than a variable rate, until the CD reaches maturity.

Once the CD matures, the new rate you earn if you decide to roll the CD over may adjust higher or lower, based on the benchmark rate. There are some exceptions to this rule, however. Some banks offer raise your rate CDs or bump-up CDs, which allow you to increase your rate and APY during your CD term, though this isn’t the norm for regular CD accounts.

APY vs. Interest Rate

A savings account or other interest-bearing account may have an interest rate and an APY. But they mean different things when saving money.

The interest rate is the rate of interest earned on an account. For example, your bank may pay you an 0.40% interest rate for your savings account. The interest rate and the APY for a deposit account may be the same or different, depending on how the bank sets them.

By itself, the interest rate doesn’t consider compounding. On the other hand, APY represents the amount of interest you could earn altogether through compounding over a year-long period.

APY vs. APR

APY and APR (annual percentage rate) may be similar, but they aren’t identical. When you’re talking about APY, you’re talking about how much interest you could earn on a bank account. When you’re talking about the annual percentage rate, you’re talking about how much interest you’ll pay to borrow money.

For example, if you have a credit card, student loan, mortgage loan, car loan or another loan, your lender will assign a specific APR to your account. This APR represents the annualized interest on the debt when the interest rate and fees are factored in. Fees that can affect APR can include loan origination fees, prepayment penalties or other costs you might pay to the lender.

APRs can be fixed or variable, depending on the type of loan. A mortgage loan, for instance, can have an adjustable rate, though fixed-rate loans are more common. With credit cards, the APR usually is variable. Similar to APYs, variable APRs may fluctuate in step with a benchmark rate. In the case of credit cards, this benchmark is typically the Prime Rate, which is the rate banks and lenders offer to their most creditworthy customers.

With APY, a higher yield is better, but with APR, it’s the opposite. The higher the APR on a loan or line of credit, the more interest you’ll pay. And the APR you pay to borrow money is typically linked to your credit score. Those with higher credit scores and seen as more creditworthy and generally qualify for a lower APR. However, your credit score has no impact on the APY you earn with a savings or money market account.

Dividend Rate vs. APY

Credit unions are non-profit, member-owned institutions where earnings are returned to members as dividends instead of interest.

To calculate dividend earnings, you’d use this formula:

A = P (1 + rt)

• A = the amount of money accumulated after n years, including interest
• P = the principal amount (your initial deposit or your initial credit card bill)
• r = the annual dividend rate (as a decimal)
• t = the number of years (time) the amount is deposited for

The formula for an account with a $10,000 balance and 1% dividend rate would look something like this:

$10,001 = $10,000 (1 + 0.0001*1)

APY represents your potential dividend earnings based on the dividend rate and compounding frequency over a year period.

How Does Compound Interest Work?

Compound interest is the interest you earn on your interest.

Simply put, it’s interest that’s paid both on the principal (that is, your deposits into the account) and on the interest you’ve earned. That’s what makes it such a powerful tool for investing, as compounding can make it possible to build wealth over the long term. On the other hand, simple interest represents interest earned on the principal deposit only.

Interest can compound over different periods. For example, it can be compounded daily, monthly, quarterly or annually.

You can use a compound interest calculator to estimate how much your money could grow over time. To use a basic compound interest calculator, you’d need to know:

• The initial deposit for the account
• How much you plan to deposit each month
• The APY and compounding frequency for the account
• How long you plan to save and allow interest to compound

Here’s an example. Say you want to open an online savings account with a $1,000 initial deposit. You plan to deposit an additional $100 per month into the account. The bank you’ve chosen offers an APY of 0.50% and the interest compounds daily.

If you were to make your monthly deposits as scheduled, you’d have $2,208 after one year. This represents $1,000 for your initial deposit, $1,200 in additional deposits and $8 in interest earned. If you were to continue your monthly savings habit and allow your money to compound over 20 years, you’d end up with $26,351.

What APY Means for Bank Accounts

Different types of banking products offer a yield, including:

• Interest-bearing checking accounts
• Traditional savings accounts
• High-yield savings accounts
• Money market accounts
• Certificates of deposit

The APY you can earn for each type of account can vary greatly depending on whether your account is with a traditional bank, online bank or credit union. APY can tell you at a glance how much your money could grow over a year.

As a general rule, the higher the APY for an interest-bearing account, the better. That’s why APY is an important consideration, alongside fees, minimum deposit requirements and other features, when choosing a new savings account, money market account or another interest-bearing account.

How To Find the Best APY

Finding the best APY savings account is something to consider if you want to prioritize growing your savings over time. Getting the highest APY means doing a little research beforehand to compare different banks and bank accounts.

How To Find the Highest APY for Savings Accounts

The first step in finding the best APY savings account is knowing where to look. Typically, this means deciding whether to open a savings account at a traditional bank, credit union or online bank.

Online banks tend to offer higher APYs to savers than brick-and-mortar banks because they have lower overhead costs. Credit unions also tend to offer competitive APYs to their members.

When comparing savings account APYs at online banks, think about:

• How that account fits your needs
• Whether the APY is flat or tiered
• What fees you’ll pay

Banks can offer a single APY for a savings account, regardless of the account balance. So you may earn the same APY on a $1,000 balance as someone who has $100,000 in their account.

Yet some banks offer a tiered-earning structure, rewarding those with higher balances with a higher rate. And some banks use the opposite strategy, paying a higher APY on balances below a certain threshold.

It’s also important to consider what trade-offs, if any, you may be making when it comes to bank fees. If you’re earning a higher APY but are expected to pay a steep monthly maintenance fee to keep your savings account open, this could negate any interest you earn.

Introductory APYs are one more thing to be aware of. To attract new customers, banks may offer a higher promotional APY for the first year your account is open and then reduce it to a lower APY afterward. If you come across a savings account with an attractive APY, be sure to consider whether that rate is ongoing or temporary.

How To Find the Highest APY for Checking Accounts

If you’re hoping to earn interest with a checking account, you may have to do some digging. High-yield checking accounts aren’t as common as high-yield savings accounts. Brick-and-mortar banks may offer them, but they tend to be reserved for customers who maintain larger balances or are willing to pay more fees to earn interest.

You could look for high-yield checking options at online banks. You won’t have branch access, but you could earn the highest APY on checking by banking online, and you may pay fewer fees or have lower minimum balance requirements in the bargain.

When comparing checking account APYs, also look at daily withdrawal and deposit limits, check-writing limits, mobile banking access and ATM access. Sacrificing convenience to earn a higher APY may not make sense in the long run.

Bottom Line

Understanding the APY is critical to making the most of your savings deposit accounts. Also, consider compounding frequency—whether an APY is compounded daily, monthly, quarterly or annually can add up over time. When interest rates are low across the board, you may feel as if you’re not earning much on your savings. However, even when rates are low, getting a better-than-average APY on your money can make a measurable difference.

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