The world of finance uses quite a few acronyms and abbreviations to address what they’re doing for us and how they're handling our money, and it can be intimidating and confusing at times. You’ve most likely heard the term “APY” bandied about – and yes, it's often confused with “APR.” But that one letter at the end makes a world of difference. And here’s a little more confusion: APY is sometimes referred to as EAR, or “effective annual rate.” In this case, the two terms mean the same thing and follow the same rules.
APY stands for “annual percentage yield,” and it provides a pretty accurate snapshot of how much your money will grow if you place it into a banking institution’s hands. The higher the APY that's offered to you, the better. You’ll hear it quoted by financial institutions who want you to deposit your money with them or invest with them, telling you how much you’ll earn in return, and assuring you that it’s more than what that other bank or institution will offer you.
The Definition of APY
The annual percentage rate quoted by a bank is a means of measuring how much interest you’ll earn on a deposit account over the course of one year, and it’s expressed as a percentage. It calculates the interest rate payable on your deposited balance plus compounded interest, which is interest earned on your balance that includes previously-earned interest. The APY gives you a much more accurate assessment of how much you’ll earn when your interest is also earning interest.
Interest can compound daily, weekly, monthly, quarterly or yearly, depending on the institution and the investment or deposit product. Your APY will be higher when compounding periods are more frequent. Quarterly compounding will earn you more on your money than annual compounding, but be wary. It’s not unheard of for a bank to promise a frequently compounded, higher APY for an introductory period of time, just to lure you in. The rate will plummet – maybe to even less than what competitors offer – after that period.
A quoted APY assumes that you’re going to place your money with the bank and leave it alone for a full year. You’re not going to add to it and you’re not going to take any withdrawals.
Your interest rate is referred to as “simple interest” if it isn’t compounded, or as a “blended” APY if different interest rates are paid depending on your balance. For example, you might earn one rate on the first $2,500 of your deposit, and a higher rate on the next $2,500 if you make a $5,000 deposit.
Read More: What Is Simple Interest?
APY vs. APR
Annual percentage rate, or “APR,” is a horse of a completely different color. This term can be used in a couple of ways.
It can refer to simple interest, either because interest isn’t compounded or because compounding isn’t taken into consideration. It will be less than the APY if interest is compounded in the account, but the quoted figure doesn’t include this in the APY calculation for some reason.
The term APR is more commonly used to refer to the interest rate you’ll pay on a loan or credit card as opposed to the interest you’ll earn on a deposit or investment. It takes into account that interest calculations on a loan can be based on additional associated fees, not just the amount you borrowed.
How to Calculate APR
You’ll obviously want to know what your APY will be before you plunk $5,000 down into a certificate of deposit, or even into a simple savings account. How much money is your money going to earn you? As a practical matter, most banks advertise their APY percentage loud and clear. Remember, the goal here is to lure in customers.
Lacking that, interactive APY calculators abound all over the internet, and they’re free to use. Many are also product-specific. Plug in the pertinent numbers and they’ll tell you what your APY will be.
Of course, you can always do things the good, old-fashioned way with a calculator or pencil and paper. The equation is actually pretty basic. Using a 5 percent interest rate with interest compounded monthly for one year on a beginning balance of $10,000 the equation, (A = P (1 + r/n) (nt), you can see that $10,000 (1+0.05/12)^12 = 10,511.62 at the end of the year. That may not seem worth it, but if you left the money at that same 5 percent for 3 years, you'd have a hefty $11,614.72 in your account, assuming there were no fees withdrawn during that time.
Likewise, you can figure out how much your APY will earn you monthly, regardless of how often interest is compounded, by dividing your APY by 12.
Read More: Certificate of Deposit Pros and Cons
APY Requirements for Banks
It’s highly unlikely that you’ll ever have to drag out your calculator or use one online to calculate your APY on any type of deposit account, from checking and savings to certificates of deposit or money market accounts. Federal law mandates that banks must make it crystal clear what your APY will be, and that they give you easy access to this information.
Federal law does not set requirements for how much or how minimal an APY must be. Banks and other financial institutions are free to decide how much they want to pay.
And again, as a practical matter, banks want you to know the APY you’ll earn, always assuming that it’s competitive. They don’t want you judging their product by that basic interest rate or APR, because that number is going to be less. By the same token, you can pretty much count on a lender quoting its APR rather than its APY on borrowed money because the APR is going to be lower and sound more attractive when a customer is borrowing.
What It Means to Your Money
You might be rolling your eyes by now because APYs can look like a mere pittance of a percentage. This might all seem like a lot of calculations for virtually nothing. Who cares if there’s a 0.012 difference between what Bank A is offering and what Bank B is willing to give you? But it can add up over time, assuming you’re a dedicated saver and in it for the long term. Maybe you're saving for retirement, and you’re not anticipating taking any or many withdrawals from that account over time.
It's always a good idea to compare APYs between institutions. It can be as easy as simply asking for the figure, always remembering that the APY might be promotional so ask about that, too. And be sure to take any minimum balance requirements and extra fees into consideration, because these will subtract from your saved balance that’s earning all this interest.
- Ally Financial: How APY Works and What It Means for Your Savings
- Bankrate: What Is APY (Annual Percentage Yield)?
- Kasasa: Everything You Need to Know About APY
- DepositAccounts: Understanding Interest Rate and APY
- Corporate Finance Institute: What Is the Annual Percentage Yield?
- Federal Deposit Insurance Corporation. "Appendix A to Part 1030—Annual Percentage Yield Calculation." Accessed July 26, 2020.
- U.S. Securities and Exchange Commission. "What Is Compound Interest?" Accessed July 26, 2020.
- American Express. "APY vs. APR: The Basics About How Interest Is Calculated." Accessed July 26, 2020.
- Consumer Financial Protection Bureau. "What Is a Credit Card Interest Rate? What Does APR Mean?" Accessed July 26, 2020.
- Consumer Financial Protection Bureau. "What Is the Difference Between a Mortgage Interest Rate and an APR?" Accessed July 26, 2020.
- University of Wisconsin. "Cheat Sheet 2," Page 1. Accessed July 26, 2020.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.