APY, or annual percentage yield, is an important figure used in the banking world to explain how much interest you’ll earn on savings account deposits. The higher the APY, the more you earn in a given year.
An account’s APY is often used in high-yield savings account marketing. Because APY includes both the interest rate and the bank’s interest-compounding policy, this number provides you with an easy way to compare two different accounts and understand which one will help you earn the most.
Understanding APY and its distinctions can make a world of difference in mastering your financial planning strategy. In this article, we at the MarketWatch Guides team will walk you through how APY is calculated, why compounding matters, how APY compares with annual percentage rate (APR) and how to evaluate APY when shopping for a bank account.
Key Takeaways
- APY reflects the interest earned on deposits in a savings account over the course of a year. This is shown as a percentage and includes the effect of compounding – the phenomenon of paid interest itself earning interest.
- APY is typically displayed on deposit accounts like checking accounts, high-yield savings accounts, money market accounts and certificates of deposit (CDs).
- APY differs from APR, which represents the amount of interest you have to pay when you borrow money.
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*Annual Percentage Yield
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How Does APY Work?
APY represents how much total interest deposits earn over 12 months, expressed as a percentage of your deposit amount.
For example, if you have $10,000 in a bank account earning a 4% APY, at the end of the year you’ll have $10,400 if you don’t deposit any more money in it.
By law, financial institutions are required to not only disclose an account’s APY, but also the frequency compound interest is added to the account.
There are two main factors that go into APY – the interest rate and the compounding frequency. We’ll explain them both below.
Interest Rate
The interest rate on your savings account is the base rate at which interest is earned. Say you have an interest rate of 3%. This means that a $10,000 deposit will earn $300 in interest over the course of a year.
However, this nominal interest rate does not include any compounding – and thus is not enough to determine your APY.
>> Related: Learn more about interest
Compounding Frequency
Interest compounding is where banks calculate your interest not only on the initial amount you put in but also on the interest you’ve earned in previous periods. This can result in exponential growth of your savings investment over time.
Interest could be compounded daily, monthly or yearly. The more frequently interest is compounded, the better it is for you as a saver.
Let’s take that $10,000 deposit again, with an interest rate of 3%. If the interest is compounded monthly, that means you’ll earn $25 in interest at the end of the first month – giving you a new balance of $10,025.
That interest rate then gets applied to the new balance, meaning you earn $25.06 in interest in the second month – bringing your total to $10,50.06.
By the end of the first year, you’ll have earned $304.16 in interest – more than the $300 in interest you would have earned without compounding. The APY would then be 3.04%.
While this may not seem like a big difference, over time and with increasing balances, this can really add up.
>> Related: Learn more by using our savings calculator
APY vs APR
While similar in concept, APY and APR are on opposite sides of the personal finance spectrum.
APY reflects the amount you earn on a savings account. APR represents the amount you pay on a loan, be it a mortgage, personal loan or credit card.
| Aspect | APY (Annual Percentage Yield) | APR (Annual Percentage Rate) |
|---|---|---|
| Types of Accounts | Savings accounts, investments, CDs, etc. | Personal loans, credit cards, mortgages, etc. |
| Components | Reflects both the base rate and the effects of compounding. | Reflects the base rate of interest and any fees. |
| Representation | Expressed as a percentage. | Expressed as a percentage. |
| Useful to compare? | Yes | Yes |
| Compounding | Yes | No |
| Fixed or Variable | May be fixed or variable depending on the terms of the financial product. | May be fixed or variable depending on the terms of the financial product. |
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Both APY and APR can be either a fixed rate or a variable rate; it depends on the account opened. With APY, for instance, a savings account would have a variable APY since it could change over time. ACD would have a fixed rate APY.
For APR, a credit card has a variable rate, while a mortgage would typically have a fixed APR.
>> Related: Learn more about the best personal loan rates
APY Formula
Here’s how APY is calculated:
APY = [1 + (r/n)]n – 1
Where:
r = interest rate
n = number of compounding periods (this could be in terms of days, months or quarters)
For example, a deposit account that earns 4% interest compounded monthly would earn 4.07% APY, as calculated below:
APY = [1 + (0.04/12)]12 – 1
APY = [1 + (0.0033)]12 – 1
APY = [1.0033]12 – 1
APY = 1.0407 – 1
APY = 0.0407, which is 4.07% when expressed as a percentage
Calculate Your Savings Growth
Use our calculator below to explore how the APY of your account can affect the interest you earn. As you shop rates with different banks, you can plug in the APY into our calculator and see how big a difference the rates make in your earnings over time.
However, keep in mind that banks can and do frequently change the APYs on their accounts. You’re not guaranteed to earn the full amount shown.
SAVINGS CALCULATOR
Enter your projected deposit, monthly contributions, term and rate to see how much your savings can grow.
SAVINGS INFORMATION
YOUR TOTAL SAVINGS $17,623
Initial Deposit $10,000
Total Contributions $6,000
Interest Earned $1,623
Factors That Affect APY
APY doesn’t exist in a vacuum. Economic factors shape what APYs are available to consumers. One example is when the United States experiences periods of inflation above optimal levels. The central bank of the U.S., the Federal Reserve (or the Fed for short), aims to keep the inflation rate at 2%.
So when inflation strays too far above 2%, the Fed raises its interest rate, called the federal funds rate. This in turn raises interest rates for both savings and loan products, with APYs (and APRs) climbing higher.
APYs can also be higher or lower based on an individual bank’s priorities. Many banks offer high-APY promotions if they’re seeking new deposits, for example. Rates on CDs may vary based on term length depending on how the bank wants to use the money.
>> Related: Learn more about the best bank bonuses
Tips for Maximizing APY
Now that you understand APY, it’s time to seek the best rates out there. An important step to not overlook, while researching the best checking or best savings accounts on the market, is for criteria that can affect your APY.
Some financial institutions have minimum balance requirements to receive a certain account APY, or a tiered system that as your account balance increases, so does your APY. Some also require you to have multiple accounts at the same time, most likely a checking account in conjunction with a savings account.
To help determine if a rate you are considering can be qualified as “good,” prospective account holders can always check against the national averages provided by the Federal Deposit Insurance Corp. (FDIC). It updates the rate average on the third Monday of each month.
High-Yield Savings Accounts
High-yield savings accounts generally have much higher APYs than standard interest-bearing savings accounts. As of April 2024, the best high-yield savings accounts have an APY of at least 4.25%. Deciding factors for picking the right high-yield savings account include not only APY, but also customer reviews, online and mobile banking capabilities, branch access and other perks.
CDs
CDs can also offer a competitive APY, but it can vary greatly depending on the bank and the term of the CD. Many banks and credit unions often have promotional CDs with high APYs for just a select few of the available term lengths, so you’ll need to confirm that the time commitment makes sense for your financial goals as there is usually a penalty involved with early withdrawals before the maturity date.
>> Related: Learn more about the best cd rates
Chasing APY
For those who want the best APY on their savings at all times, it can be tempting to consistently move deposits from one financial institution to the next in an effort to chase the best deal. But closing your high-yield savings account and sending the funds elsewhere in exchange for earning a few fractions of a percent more is often more trouble than it’s worth.
Unless your bank or credit union APY is lagging significantly behind competitors or you’ve had a bad experience with the financial institution itself (such as a glitchy mobile banking app or sour customer service), it’s likely best to keep your high-yield savings account or other high interest deposit product intact.
>> Related: Learn more about the best online banks
The Bottom Line
Annual Percentage Yield measures the amount of interest you earn in a certain deposit account. It is influenced by the interest rate as well as the compounding frequency.
APY is a more thorough indicator of the interest you will earn than just an interest rate, and has become the preferred method of reporting interest for not only checking and savings accounts, but also for CDs and money market accounts.
It’s important to consider all of the information available before opening any bank account, including APY, fees and any account requirements.
FAQ: Annual Percentage Yield
It means a deposit will earn 5% interest per year, including compound interest. However, a 5% APY doesn’t specify how often interest compounds, such as daily or monthly, so it’s good to check this with the financial services provider.
Over one year, a $5,000 deposit with a 5.00% APY compounding monthly would earn nearly $250 of interest. But if $5,000 was left untouched over five years while earning 5% APY, it would earn $1,378.56, in part thanks to compound interest, for an end total of $6,378.56.
It depends on the interest rate environment of the moment and the type of financial product. For example, a 3% APY on a high-yield savings account in April 2024 would be subpar, since currently there are many high-yield savings accounts with over 4% APY. In contrast, a high-yield savings account earning 3.00% APY in January 2021 would’ve been a good deal, as most accounts at the time offered APYs well under 1.00%.
*Rates accurate as of 4/2/2024
**Data accurate at time of publication
If you have feedback or questions about this article, please email the MarketWatch Guides team at [email protected].
