Knowing how annual percentage yield (APY) and interest rates work is essential when shopping for a savings account. Interest rates and APY measure how much you might earn annually for every dollar you save. Here's a closer look at APY vs. interest rate so you can make the most informed saving decisions.
APY vs. Interest Rate: Key Differences
What is an interest rate?
In personal finance, the interest rate measures how much you'll earn from a savings account every year. You can think of it as the "base" amount that a bank or other financial company pays you for keeping your money with them. It's usually expressed as a percentage. For example, if you save $100 in an account paying 1% simple interest, you will earn $1 by the end of the year.
The interest rate tells you how much money you'll earn over a year before taking any other factors into account.
What is APY?
APY also measures how much interest you earn, but includes a powerful concept known as compounding. With APY and compound interest, the amount of interest you earn also includes past interest earnings. If an account compounds more frequently, you'll earn a higher APY, even with the same interest rate.1 In simpler terms, APY is the "total package" that tells you the amount you'll earn in a year, considering how often the interest is added to your account.
The formula for calculating APY is below, but you can use handy, free calculators to do the hard work for you in most situations.2
APY = 100 [(1 + Interest/Principal)(365/Days in term)−1]
To better understand APY, here's an example. Assume you save $1,000 in an account and earn 1% interest. Here's a look at what you would earn with this account over five years. As you can see, interest earnings increase a little bit each year.
| Year |
Opening Balance |
Interest Earned |
Closing Balance |
| 1 |
$1,000.00 |
$10.05 |
$1,010.05 |
| 2 |
$1,010.05 |
$10.15 |
$1,020.20 |
| 3 |
$1,020.20 |
$10.25 |
$1,030.45 |
| 4 |
$1,030.45 |
$10.35 |
$1,040.80 |
| 5 |
$1,040.80 |
$10.45 |
$1,051.25 |
With compound interest, more accurately measured with APY, the amount you earn over time grows even if the interest rate stays the same.
READ MORE: How Compound Interest Works
How to Decide Whether to Use APY or Interest Rate
When dealing with saving, you'll almost always want to use APY to understand your earnings and compare options. A simple interest rate is ideal for loans and savings when interest is only added once. You'll probably want to use APY for savings.
With saving, your goal is usually to earn as much as possible. APY helps you understand and compare how much you would earn from an account. For example, if a one-year certificate of deposit (CD) and a high yield savings account pay the same interest rate, you'll still need to use APY to determine which pays you the most over a year.
If both accounts pay a 5% interest rate and you deposit $1,000 at the beginning of a year, you may see different earnings at year-end. If the CD compounds annually and the savings account compounds monthly, your APY would be higher with the savings account because you would earn interest monthly, and future interest would be based on the most recent balance.
Benefits of Using APY
With APY, you have a more accurate representation of your true interest earnings from an account. And because different accounts have different interest rates and compounding periods, you can use APY to get the best comparison of several options.
While it's a little more complicated to calculate, many banks provide APY with other account details, so you don't have to worry about the math. With APY in mind, you'll understand the higher return you earn across different accounts and can make better plans for what you'll have at the end of a month, year or other time period.
Benefits of Using Interest Rate
Interest rate is simpler and easier for most people to understand. When you start learning about percentages in elementary school, you're using the equivalent of a simple interest rate, not an APY with compounding.
Outside of the financial world, the interest rate is more commonly used and understood. It's quick and easy to calculate, but not always as telling as APY.
Examples of APY and Interest Rate Used in Real-life Banking
To better understand interest rate vs. APY, here are some helpful examples similar to what you may encounter when managing your money.
APY example: Certificate of deposit
To better understand how APY works, let's assume you open a CD account with $5,000 that compounds monthly for five years. If we assume a 4% interest rate, thanks to monthly compounding, the APY would be 4.074%.
If the account compounded annually with a 4% interest rate, you would earn $1,083.26 over five years, for a total ending balance of $6,083.26. While earning over $1,000 is great, you earn more when considering the compounding schedule with APY. At 4.074% APY, your earnings are $1,104.98, with a final balance of $6,104.98.
The difference between the two is more than $21. The difference grows if you save more or for a longer period.
Using APY to Grow Your Wealth
Knowing how to use APY, you can make confident and informed decisions to move your finances forward. Whether saving for a specific goal or for retirement, you can use APY to pick the best account for your unique needs.
If you want to earn top APYs, check out Synchrony Bank's high yield savings, money market and CD accounts. You could put yourself on track to earning excellent rates while keeping your money safe and preparing for your optimal financial future.
Eric Rosenberg is a financial writer, speaker and consultant based in Ventura, California. He holds an undergraduate finance degree and an MBA in finance. He is an expert in banking, credit cards, investing, cryptocurrency, insurance, real estate and business finance. He has professional experience as a bank manager and nearly a decade in corporate finance and accounting. His work has appeared in many online publications, including Business Insider, NerdWallet, Investopedia and U.S. News & World Report. You can connect with him and learn more at EricRosenberg.com.
READ MORE: Important Banking Terminology Everyone Should Know
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