APY Vs. Interest Rate: What’s The Difference?

When researching savings accounts, you’ll likely come across two key figures: Annual percentage yield (APY) and interest rate. While they may seem similar, understanding their nuances is important for calculating and maximizing your financial returns.

Here’s a breakdown of the two numbers, how they differ and why it matters when you’re finding the right bank account.

What is the difference between APY and interest rate?

The APY on a savings account and the interest rate associated with the account have different roles.

• APY: APY is the amount of interest your savings account can earn over the course of a year. It includes the effects of compounding interest. With compounding, the interest you earn is added to your balance, and future interest calculations are based on this larger amount. The APY reflects this cumulative effect, making it a transparent indicator of your total return potential.
• Interest: The interest rate is the base rate at which the deposits in a savings account earn money. An interest rate is a simple, straightforward percentage that doesn’t account for compounding.

Both APY and the interest rate indicate how much you can earn from a savings account or investment, but they do so in different ways.

APY vs. interest rate example

To illustrate how APY and interest rate differ, consider this example: Suppose you deposit $1,000 into a savings account with an interest rate of 4 percent. If this were a simple interest rate, you would just earn 4 percent of $1,000 after a year, which amounts to $40 earned. However, most savings accounts compound multiple times within a year, so let’s say the 4 percent interest rate compounds monthly. After a year, you’d have $1,040.74.

Considering the effects of compound interest, your $1,000 deposit is effectively growing at a rate of approximately 4.07 percent annually, not the simple 4 percent interest rate.

If you’re looking at one bank account that offers a 4 percent interest rate and another that offers a 4 percent APY, the account with the 4 percent interest rate may actually earn more if it’s compounded.

While this difference might seem small, it becomes more pronounced as you deposit more money and as the money is invested for longer periods of time. (Banks are required to list the APY for their deposit products.)

When comparing savings accounts, look at the APY rather than the interest rate, as it gives a more accurate picture of your potential earnings over a year by factoring in compounding.

“When shopping around for a savings account, you should prioritize the highest APY you can find, as this will provide the highest yield on your investment,” says Steve Sexton, CEO of Sexton Advisory Group. Sexton explains that APY factors in the effect of compounding interest, whereas the interest rate does not. This means interest earned is added to the principal balance and then earns interest itself, which earns you a higher overall return.

High-yield savings accounts are a great option for those looking to get the highest possible earnings. Some of the top-yielding accounts are offering APYs of over 4 percent, as of this writing, while some traditional savings accounts at the largest banks are still only earning 0.01 percent APY. Note that many of the highest-yielding accounts are at online-only banks.

Remember, too, that a good savings account does more than just provide a high APY. Look out for various bank fees, such as monthly maintenance fees and overdraft fees, as these can reduce your earnings and even potentially cancel out the APY, if you’re earning less than what you’re paying in fees. Also compare digital features and customer service options.

“It is important to understand what fees you’re responsible for, including maintenance and overdraft fees,” says Sexton. “If you’re earning less than what you’re paying in fees, a high APY may not matter, so be sure to read the fine print.”

While high-yield savings accounts are a great choice for short-term savings goals and storing an emergency fund, you may also want to consider certificates of deposit (CDs) for longer-term goals. Some CDs may offer a higher yield than a savings account, and if you lock in at a high rate now, the CD will continue to earn that rate until it matures — unlike a savings account, which comes with a variable rate. However, early withdrawals from CDs often come with penalties.

Bottom line

A bank account’s APY incorporates the effect of compounding interest. This means you earn interest on the accumulated interest, rather than just on the money you deposited into the account. Looking at an account’s advertised APY, rather than just its interest rate, can give you a more accurate picture of how much your money will earn over time.

Because not all savings accounts are created equally, shopping around for one with a competitive yield is a good idea, as well as looking for accounts with no monthly fees and no minimum balance requirements.