How Is APY Different from Interest Rate?
A simple interest rate tells you the base percentage your deposit earns, but it ignores compounding. APY includes compounding, which means interest earned in earlier periods generates additional interest in later periods. The more frequently interest compounds, the higher the APY relative to the stated rate. For comparing deposit accounts, APY is always the better metric.
How Is APY Calculated?
APY is calculated using the formula: APY = (1 + r/n)^n − 1, where r is the annual interest rate and n is the number of compounding periods per year. A 5% rate compounded daily yields a higher APY than 5% compounded monthly. Banks are required by federal law to disclose the APY on deposit accounts so consumers can make fair comparisons.
Why Does APY Matter When Choosing a Bank Account?
APY is one of the most useful numbers for comparing potential earnings across different savings accounts, CDs, or money market accounts. A small difference in APY can compound into meaningful earnings over time. Online banks and credit unions typically offer higher APYs than traditional brick-and-mortar banks because they have lower overhead costs.
Frequently asked questions
Is APY guaranteed to stay the same?
On variable-rate accounts like savings accounts, APY can change at any time based on market conditions and the bank's decisions. Only fixed-rate products like CDs lock in an APY for the full term.
Does APY apply to loans?
No. APY measures what you earn on deposits. The equivalent measure for loans and credit cards is APR (Annual Percentage Rate), which reflects the cost of borrowing including fees.
Can APY be negative?
In practice, US deposit account APYs do not go negative. However, if account fees exceed the interest earned, your effective return can be negative even though the stated APY is positive.