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Understanding APY and Interest Rates
Annual percentage yields (APYs) and interest rates are key metrics that indicate how much you can earn from depositing money into an interest-bearing account, such as a savings or money market account. However, they are not the same. APY includes compounding, providing a clearer picture of your annual earnings, which is why financial institutions must use APYs when describing their deposit accounts.
APY vs. Interest Rate
Annual Percentage Yield (APY)
An account’s APY considers both the interest rate and compounding to help you understand your potential annual earnings. For instance, if you deposit $100 in a high-yield savings account with a 5% APY, you will earn $5 over the year. Certificates of deposit (CDs) often offer a fixed APY for a specific term, making it easier to compare and choose the most profitable account.
Interest Rate
Interest is the cost of borrowing money. When you deposit money in an interest-bearing account, the financial institution pays you interest to use your money. Conversely, you pay interest when you borrow money, such as for a mortgage. Interest can be simple or compound. Simple interest applies only to the principal balance, while compound interest applies to both the principal and any accrued interest.
APY vs. Interest Rate Example
If an account uses simple interest, the interest rate and APY will be the same. However, with compound interest, the APY will be higher than the interest rate. Consider a CD with a 5% interest rate and a one-year term. If the interest compounds monthly, the interest is added to the principal balance each month, leading to more interest earnings the next month.
Here’s an example with a $1,000 CD:
| Month | Interest Earned | Ending Balance |
|---|---|---|
| 1 | $4.17 | $1,004.17 |
| 2 | $4.18 | $1,008.35 |
| 3 | $4.20 | $1,012.55 |
| 12 | $4.36 | $1,051.16 |
The CD has a 5.12% APY, earning you $51.16 on your $1,000 deposit over the year. Without compounding, you would only earn $50, and both the interest rate and APY would be 5%. When searching for CD rates, you’ll see the APY, not the interest rate.
Which One Is More Important to Know for Savings Accounts?
Understanding how interest rates and compounding affect an account’s APY is useful, but the APY is ultimately the more important number. The APY takes the interest rate into account, making it easier to compare different accounts. Regulators generally require banks and credit unions to advertise the APY, so you can easily determine which account offers the most interest.
The Bottom Line
No matter the type of compounding your savings account uses, the key is to save money that earns interest. A clear savings strategy and goals can help you build your savings and reach your financial objectives without incurring additional debt. Whether you’re building an emergency fund or planning a vacation, it’s reassuring to know you have money ready when you need it.
For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you achieve your financial goals!
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