Anyone who has ever opened a bank account has heard the terms interest rate and annual percentage yield (APY). Although the two are related, knowing the difference will affect the return you’ll ultimately get on your money. APY refers to the amount of interest your account actually earns in a year. Although two banks may pay the same interest rate, the way they apply that interest could affect the balance in your account.
The interest rate on a savings account or investment is fairly straightforward if interest is only paid once a year. If you deposit $1,000 in an account paying 5 percent interest, at the end of the year you will have earned $50. If you leave the interest in your account, it will begin earning interest of its own, and your balance will start to grow more rapidly. Because of this concept, called compound interest, your APY will actually be more than the annual interest rate if interest is compounded more frequently.
Example of APY
Imagine you put $1,000 in a savings account earning 12 percent interest. If interest is only compounded yearly, at the end of the year you’ll have $1,120 in your account. But the situation changes if interest is compounded monthly. Each month, your account will earn 1 percent interest (12 percent divided by 12). At the end of the first month, you will have earned $10, and the next month you would receive interest on your new balance of $1,010 (totaling $10.10). After 12 months, you would actually have $1,126.83, for an APY of 12.683 percent.
Using the APY allows you to compare accounts and investments among different institutions, because it reflects how often interest is compounded. Using the above example, if two banks were each offering 12 percent interest, but one compounded interest yearly, and the other monthly, it’s clear that the bank with more frequent compounding offers a better rate of return. The APY makes it easier to shop for rates, because it indicates how often interest is compounded.
The APY assumes that you will leave the money untouched for the entire year. Of course, if you deposit or withdraw money from the account, your yield will go up or down. APY also does not take into account any applicable fees or charges. When these costs are applied, your yield will be reduced. Consider fees when comparing accounts, as an account with a lower APY and no fees will often be a better deal than one with a higher APY and account charges.
Don’t confuse interest rate and APY with the annual percentage rate (APR) used when discussing credit cards and loans. Lenders and credit card issuers can advertise different rates, but they are required by law to clearly state the interest you will pay annually before issuing you credit. For example, a credit card company can offer a monthly interest rate of 1 percent, but must disclose the APR of 12 percent before giving you a card. Unlike with savings accounts, look for loans which compound interest less frequently.
Ben Bontekoe is a published writer with an extensive background in personal finance, banking, career counseling and education. A graduate of Calvin College, he has worked for major financial institutions including Bank of America and Citibank.