You may have noticed that savings accounts, certificates of deposit (CDs), money market accounts, and more have an annual percentage yield (APY) associated with them. What does APY mean? It’s not the same as the interest rate. Here’s how APYs work—and what they mean for your money.
What is APY?
The APY is the real annual rate of return on an interest-bearing account. That doesn’t mean your interest rate—what you’ll be paid on the money you deposited within a certain timeframe— is meaningless, but it doesn’t tell the whole story. The APY accounts for compound interest, which is interest earned on your balance plus interest earned on interest.
Need an example? Let’s say you deposited $5,000 into a savings account. If the interest rate were 4% (meaning interest paid on the initial sum only), you’d have $5,200 after a year. If the APY were 4% compounded daily, though, you'd have $5,204 after a year. That $4 isn’t a big difference after a year, but small increments can add up over time, especially with larger balances, a competitive APY, and a frequent compounding interval. Many accounts compound interest much more often than annually, such as daily, weekly, monthly, or quarterly.
Thanks to compounding, your APY often ends up higher than your account’s interest rate, which is why it’s considered a more accurate rate of return. When shopping for an interest-bearing account, consider the ones with the highest APY.
APY formula and how to calculate APY
To calculate APY, you can use an online compound interest calculator. Or bust out your middle school algebra skills and use the following APY formula:
APY = [1 + (i / n)]n − 1
i = the interest rate
n = the number of times interest compounds during the year
Here’s how to crunch the numbers with a savings account that pays 4% interest (0.04) and compounds interest daily (365 times per year). If you plug those numbers into the APY formula, you get: APY = [1 + (.04 / 365)]365 − 1
- Now divide the interest rate by the number of compounding
periods: APY = [1 + 0.00011]365 − 1
- Then add the 1:
APY = [1.00011]365 − 1
- After that, whip out your calculator to raise this number to the 365th power to
get: APY = 1.041 − 1
- Take away the 1, and you’ve got your APY:
0.041 (or 4.1%)
APY vs. APR
An annual percentage yield is interest you earn, while an annual percentage rate (APR) is interest you pay. While APYs are associated with savings accounts, CDs, and money market accounts, you’ll see APRs on lending products like credit cards, lines of credit, and loans— where you pay interest on money borrowed. The APR also includes fees. Generally, you want a lower APR to pay and a higher APY to earn.
APY vs. interest rate
While APYs and interest rates are both percentages, they usually represent 2 different things: APYs factor in compound interest, while interest rates do not. If you have an account or a product like a brokered CD that does not compound interest, then your APY and your interest rate will be the same.
Evaluating APYs
Now that you know what APY is, here’s what it actually means for your financial life.
Fixed vs. variable APY
Before opening an account, clarify whether your rate will be fixed or variable.
- Fixed APYs remain constant for a defined period. For example, a 3-month CD may have a 4.25% fixed APY for the entire term.
- Variable APYs can change. You’ll find variable rates on savings accounts and certain CDs. APYs are influenced by the federal funds rate, a benchmark rate set by the Federal Reserve. When this rate goes up or down, APYs usually do too. You won’t be able to predict what the rate will be in the future, but you can find out how often the rate can adjust.
What is a good APY?
What’s considered a “good” APY has a lot to do with current market conditions. Again, interest rates on deposit accounts usually follow Federal Reserve moves. If the Fed raises interest rates, APYs will usually be higher, and vice versa.
What’s considered a good APY can also vary by account. Savings accounts tend to have lower APYs than CDs, for instance. That’s because financial institutions pay you a premium to guarantee your money stays with them for a set period of time, as with CDs. But you could withdraw your money anytime with a standard savings account, so APY is generally lower.
How to get the best APY
To find the best APY, the internet is your friend. Start by researching a range of financial institutions’ offerings. Don’t just consider APYs, though—factor in account fees and features. This will help you choose an account with a strong APY that also fits your needs.
Don’t forget to compare account types as well. For example, the APYs offered on savings and money market accounts might vary significantly from those offered for CDs, but you might find that a CD meets your needs best. Other types of accounts, like cash management accounts, may be lesser known but can offer advantages of both savings and checking accounts, like higher APYs and the ability to pay bills.