What is an APY?
Annual percentage yield is the earned interest rate on your money in a bank account
If your current savings account is only earning 0.01% to 1% annual percentage yield (APY), you are missing out on the opportunity to grow your money.
Interest rates have increased recently, and the higher your APY, the more money you can earn just from your savings sitting in the bank or a specialized savings vehicle, like a certificate of deposit (CD) or money market account (MMA).
Key insights
- APY is an annual rate, meaning it assumes you leave your initial investment untouched for a full year.
- Some savings products, such as CDs, are safe from fluctuating APY rates.
- Look for promotional or introductory APYs for higher-than-average rates on limited-time saving products.
APY definition
APY is a way to measure the return on an investment over a period of one year. You probably already have a savings account or savings vehicle that is earning APY. If you don’t know what the current APY is on your savings, now is a good time to compare rates with other banks and credit unions.
How to calculate APY
The formula for calculating APY is:
APY = (1 + r/n)n - 1
where:
- r is the annual interest rate
- n is the number of times the interest is compounded per year
To calculate the APY for an investment with a 4% annual interest rate compounded annually, it would look like this:
- APY = (1 + r/n)n - 1
- APY = (1 + 0.04/1)1 - 1
- APY = 0.04, or 4%
The APY for this investment would be 4%, which is the effective annual yield taking into account the compounding effect of the interest. This means that if you invested $1,000 in this investment for a year, you would earn approximately $40 in interest (assuming no additional deposits or withdrawals).
Let’s give another example, with interest that’s compounded quarterly and has a 2.5% annual interest rate. In this case, APY would calculate like this:
- APY = (1 + r/n)n - 1
- APY = (1 + 0.025/4)4 - 1
- APY = 0.0252, or 2.52%
So, the APY for this investment would be 2.52%. If you invested $1,000 in this investment for a year with no deposits or withdrawals, you would earn $25.20 in interest.
What is compound interest?
Compound interest allows you to earn interest on your original amount plus the interest you've already earned. It is interest that builds upon itself. This means that your money can grow faster than it would with simple interest, which is the interest earned only on the original amount.
The formula for calculating compound interest takes into account the principal amount, the interest rate, the number of compounding periods per year and the length of time you're investing or borrowing for. The more often interest is compounded, the more your money will grow over time.
» MORE: How to manage your money
What’s a good APY rate?
APY rates change frequently, so how do you know if you are getting a good rate? Andrew Latham, a certified financial planner, said, “In general, anything that is two percentage points higher than the national average is a good APY.”
Latham gave an example to match the average rates at the time of publication: “Currently, the average national deposit for 12-month CDs is 1.36%, so anything above 3.36% APY is decent,” Latham said. “The average MMA is 0.48%, so look for money market accounts that offer an APY that is 2.5% or higher.”
This rule can be used no matter how much rates fluctuate. It is a good idea to compare interest rates at credit unions and online banks, too. These institutions typically offer higher rates on savings accounts compared with traditional brick-and-mortar banks.
» MORE: Best online savings accounts
Savings products with high APY rates
You have many options to choose from if you want to earn a higher APY on your savings. Here are four of the most common choices:
Savings account
High-yield savings account
Certificates of deposit
Money market accounts
APY vs. APR: what’s the difference?
The key difference between APY and annual percentage rate (APR) is that:
A higher APY is good for deposits, while a lower APR is better for borrowing money.
- APY is used to express the interest earned on savings and investment products.
- APR is used to express the interest charged on debt products.
Additionally, while APY considers compounding interest, APR does not.
Basically, APY measures what a bank or financial institution pays you to keep your money in an account, while APR measures what you pay a bank, lender or financial institution for borrowing money.
Ideally, you want a high APY but a low APR when it comes to financial products.
FAQ
Is a high APY good?
A high APY is generally a good thing because it means you can earn more interest on your investment or deposit. However, it's important to also consider other factors, such as fees and restrictions, before choosing an investment or savings account.
How often is APY typically compounded?
The frequency of compounding interest varies depending on the type of account or investment and the financial institution. Savings accounts and money market accounts may compound interest daily, monthly, quarterly or annually. Typically, most high-yield savings accounts compound interest daily, allowing your money to grow even faster.
Are there any risks with a high-APY product?
The typical savings account or CD comes with minimal to low risk. However, there is some risk with high-APY products that have restrictions or requirements that could result in lower returns or additional fees. There is also the potential for rate fluctuations, which can result in lower rates.
Bottom line
Knowing what APY is and how much your savings are earning is important. It’s a good idea to regularly reevaluate the APYs of your savings products because these rates can fluctuate over time. By keeping a close eye on APY and comparing different options, you can ensure you are getting the highest return possible and adjust your savings strategy as needed to achieve your financial goals.
