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Interest Rate vs. APY: Understanding the Fine Print in Your Savings Account

laurenbrown
Lauren Brown Updated: June 28, 2023 • 6 min read
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When managing personal finances, the terms interest rate and annual percentage yield (APY) regularly come up. Though they are often confused as interchangeable, there is a distinct difference between APY and interest rate, with each playing a central role in determining the growth of your savings. As you evaluate available investments, consider the APY vs. interest rate on your savings account and how each will impact your finances.

Defining Key Terms: Interest Rate and APY

The profitability of your savings is directly affected by two fundamentals: interest rate and annual percentage yield (APY).

  • Interest rate: Think of this as the reward you get for lending or investing money, presenting itself as a percentage of your initial deposit amount. 
  • Annual percentage yield (APY):  Incorporates the effect of compound interest. Compounding occurs when the money you earn on your initial deposit also starts making interest. Thus, by accounting for this effect, APY shows a more accurate picture of your annual earnings.

Let’s examine these concepts further using a simple example. Suppose you have $10,000 to deposit in a savings account; how much would you have at the end of one year if the annual interest rate is 2%? After 12 months, you would have earned $200 in interest ($10,000 x 2%) for a total of $10,200. 

If we compound the 2% rate monthly, you will earn slightly more than $200 in the first year, bringing your balance to $10,202. That is because you are making interest on your interest every month thanks to the power of compounding. While an additional $2 return may seem insignificant, it can add up in the long run, especially when investing sizable amounts of money. 

What is APY on a savings account for this example? The APY is 2.018%, calculated as APY = (1+r/n)n – 1. In this calculation, r is the 2% interest rate, and n is the number of compounding periods in the year, in this case, 12. With this example, we can see the power of compounding and how APY vs interest rate compare.

 

Difference Between Interest Rate and APY

Interest rates and APY are integral to personal finance, but serve distinct purposes and provide different insights:

  • Interest rate: Reflects how much your investment earned without considering compounding. 
  • APY: Takes the interest rate equation one step further by incorporating the effect of compounding into its calculation.

APY accounts for how often the interest is applied, whether annually, quarterly, monthly, or daily. In other words, APY indicates the interest you will receive on both your initial deposit and previously earned interest. APY will get larger as the frequency of compounding increases because the interest you have already received is now making more interest. 

When comparing APY vs interest rate, consider APY as a complete view, telling you the total interest you can earn over a year. The difference between APY and interest rate becomes especially significant in long-term savings strategies, where compounding has a more substantial effect. 

Understanding Your Savings Account Statement

Many Americans know that having a savings account is a significant first step towards enhancing their financial well-being, but understanding your savings statement can be challenging. You can use two critical pieces of information to evaluate your investment: the interest rate and the annual percentage yield (APY). 

  • Interest rate: You can typically find this in your statement's account details or summary section. It is a yearly rate provided as a percentage. You can interpret this number as your deposit's interest without taking into account compounding effects.
  • APY: You should be to find your APY rate directly on your statement. If not, you can use the following formula to calculate it: APY = (1+r/n)n – 1

In this formula, r represents the interest rate, expressed in decimals, and n is the number of compounding periods per year. Consider an interest rate of 2%, compounded monthly, similar to our previous example. In this case, the APY would be 2.018%, calculated as follows:

APY = (1+0.02/12)12 – 1 = 0.02018 or 2.018%

The APY shows the effect of compounding, so you can use this rate to interpret the total interest you can earn during the year. If you are analyzing APY vs interest rate, APY could be more insightful because it offers better insight into the interest you will receive over time.

 In comparing APY vs interest rate, the goal is not just to choose the higher rate but to identify how each contributes to your savings objectives.

Impact of Interest Rate and APY on Your Savings

Your account's interest rate and APY both influence your savings growth. The key difference between the two is that the APY incorporates the effects of compounding, providing a more comprehensive picture of your returns. However, the real impact comes down to the frequency of compounding. 

To best understand interest rate vs. APY savings account returns, consider the scenario where you have deposited $10,000 into a savings account. If the bank offers an interest rate of 2% compounded annually, your balance after one year using a simple interest calculation would be $10,200. The APY would also be 2% in this case because of annually compounding interest. This leaves your total account balance the same at $10,200. 

The difference between APY and interest rate shows when the compounding frequency increases, and this is where it will impact your investment. Continuing our example, suppose the interest is now compounding quarterly. The interest rate remains 2%, but the APY rises to approximately 2.015% because it accounts for the impact of quarterly compounding. Consequently, your balance would be about $10,202 at year-end, slightly more than with annual compounding. 

Choosing Between High-Interest Rate and High APY: What’s Better?

When choosing a savings account, you may have a choice between a high-interest rate and a high APY, causing you to wonder which one to pay attention to. Is a larger interest rate or APY better? Both are significant, but their relevance may depend on the compounding frequency. 

The interest rate and APY will be identical if the interest compounds annually. If that is the case, you can focus on finding the highest rate, regardless of the measure. If the interest is compounded more frequently, such as daily, monthly, or quarterly, then there is a difference between the two rates. When compounding occurs more than annually, a savings account with a lower interest rate but higher APY could yield more at the end of the period. Understanding the difference between APY and interest rate can help you identify the more profitable account and make a more informed decision.

Conclusion

While the terms may initially appear similar, there is a difference between APY and interest rate. The interest rate offers a simple view of what you earn annually without compound interest. The annual percentage yield (APY) is the rate that considers compounding, providing a more precise picture of your potential earnings. The effects of compound interest are why the APY is generally higher than the interest rate when compounding occurs more frequently than once a year.

In evaluating your current savings plan, consider the interest rate listed on your statement and calculate the APY for a comprehensive view of the return you could earn. In comparing APY vs interest rate, the goal is not just to choose the higher rate but to identify how each contributes to your savings objectives. The more aware you are of these elements, the better positioned you will be to navigate the financial landscape and manage your savings effectively.

FAQ

1. Is annual percentage yield the same as interest rate?

While the annual percentage yield (APY) and the interest rate both describe how much you can earn from a savings account, they differ. An interest rate indicates the simple annual return. In contrast, APY factors in the frequency of compounding, providing a more accurate projection of your potential earnings for the year. The APY will be the same as the interest rate if there is annual compounding.

2. Is a higher APR or APY better?

APR is the annual percentage rate often used when discussing interest owed by a borrower. APY, on the other hand, refers to interest earned by a saver. 

Choosing between a higher APR or a higher APY depends on your financial circumstances and goals. A lower APR is typically better for borrowers, as it means less interest to pay. A higher APY is generally best for savers as it translates into more earnings. 

3. What is a good APY rate?

A reasonable APY rate can vary depending on the current economic environment and the investment product. As of June 2023, the APY for a savings account is around 0.33%. High yield savings accounts offer a slightly higher return, with an APY currently ranging from 3.75% to 4.85%. It is crucial to monitor rates in real-time, though, as they can change.

faq-icon

Is annual percentage yield the same as interest rate?

While the annual percentage yield (APY) and the interest rate tell how much you can earn from a savings account, they differ. The interest rate indicates the simple annual return. In contrast, APY factors in the frequency of compounding, providing a more accurate projection of your potential earnings for the year. The APY will be the same as the interest rate if there is annual compounding.

Is a higher APR or APY better?

While we have extensively covered the difference between APY and interest rate, you may be wondering about APY vs APR. APR is the annual percentage rate often used when discussing interest owed by a borrower. APY, on the other hand, refers to interest earned by a saver. Choosing between a higher APR or a higher APY depends on your financial circumstances and goals. A lower APR is typically better for borrowers, as it means less interest to pay. A higher APY is generally best for savers as it translates into more earnings.

What is a good APY rate?

A reasonable APY rate can vary depending on the current economic environment and the investment product. As of June 2023, the APY for a savings account is around 0.33%. High yield savings accounts offer a slightly higher return, with an APY currently ranging from 3.75% to 4.85%. It is crucial to monitor rates in real-time, though, as they can change.

laurenbrown
Written by Lauren Brown linkedin-icon

Lauren has over a decade of experience in wealth management and financial planning. She is a CFA charterholder and holds a Bachelor's degree in Finance. Lauren has worked with several asset management firms, offering wealth advisory and portfolio management services to high-net-worth clients.