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You check the interest rate on your savings account and find out it pays 0.03% APY. Annual Percentage Yield (APY) is related to your interest rate, but it's not exactly the same thing. APY is your actual rate of return over the course of a year on a savings, money market, certificate of deposit (CD) or other interest-earning account. APY accounts for the fact that your money grows throughout the year as you earn interest, so you typically earn more than the stated interest rate on your account.
Here's more on how APY works.
What Is Annual Percentage Yield (APY)?
APY uses compound interest to determine your real annual return on an interest-earning account. Compounding simply means adding the interest you've earned to your principal balance. If you earn $5 on your $500,000 balance today, tomorrow you will earn interest on $500,005.
Interest may compound daily, monthly, annually or at a specified rate. Savings accounts and money market accounts may compound daily or monthly. A CD typically pays interest at the end of its term. A 12-month CD, for example, pays interest when it matures a year after it's opened.
Interest-earning accounts may also have fixed or variable interest rates. Interest on a savings account, for example, often rises and falls as the Fed adjusts interest rates. A CD, on the other hand, usually has a fixed rate for the duration of its term. Some CDs allow you to adjust your interest rate once during the term if interest rates rise, a feature to look for if you think interest rates are going up.
How to Calculate APY
You can use an online APR to APY conversion calculator to convert a straight interest rate to APY. Or, if you'd rather do the math yourself, use the following standard formula. Start with these two variables:
- i = interest rate, written as a decimal (2% interest is 0.02).
- n = the number of times your interest compounds in a year. If monthly, it compounds 12 times.
Plug these variables into the conversion formula:
APY = [1 + (i / n)]n — 1
If your algebra is a little rusty, here's how to run these numbers step by step. Say your account earns 2% interest and it pays interest monthly:
APY = [1 + (.02 / 12)]12 — 1
1. Divide the interest rate by the number of times your interest compounds in a year.
[1 + 0.0017]12 — 1
2. Add 1 to the number you got in step 1.
[1.0017]12 — 1
3. Raise the result by n, the number of compounding periods: 12.
1.0202 — 1
4. Subtract 1. Convert the decimal back to a percentage.
0.0202 or 2.02%
Skip the Math and Use a Compound Interest Calculator
If you'd rather skip this math—and you're more interested in how your money will grow over time―use an online compound interest calculator instead. Plug your interest rate (not APY), number of compounding periods and starting account balance into the calculator to project how much your account will be worth at any point in the future.
Find High-Yield Savings Accounts
How APY Affects Your Returns
In our earlier example, the APY on an account earning 2%, compounding monthly, was 2.02%. If you deposited $10,000 into this account today—and interest rates remained constant—a year from now you would have $10,202, $2 more than the $10,200 you would have at a simple interest rate of 2.00%.
Admittedly, earning an extra $2 on a $10,000 deposit doesn't make much of a difference to your finances. But, compounding can have a greater impact when your account balance is higher, when your account has more time to compound and grow or when interest rates are high. The main takeaway is that compounding increases your return on interest-earning accounts, and it's the main reason your APY—or actual return—is greater than the simple interest rate on your account.
Use APY to Compare Accounts
One additional note: APY can be especially helpful when you're trying to compare accounts. A high-yield savings account and a CD may have different interest rates and compounding schedules, which makes it difficult to compare apples to apples. APY lets you see what each account will pay in a year, simply.
What's the Difference Between APY and APR?
For interest-earning accounts, APY is the annual return on your money with compound interest; APR is the annual percentage rate without it. Banks, credit unions and investment firms often show APY instead of APR, since APY is usually higher and may be a more useful metric for comparison. On accounts with very low interest, APR and APY may appear to be the same. This is generally because the difference between the two numbers is too small to show up.
APR on a loan or credit card account generally refers to something different. Here, APR measures the costs associated with your loan or credit:
- APR on a loan is the total cost of interest, fees and costs, divided by the number of years on the loan.
- APR on a credit card is the interest rate the card issuer charges when you don't pay off your balance. It does not include fees.
The Bottom Line
APY can help you more clearly understand what you're earning on savings, money market or CD accounts by taking compound interest into account. It's also useful when you're comparing different types of interest-earning accounts and want to see how they stack up. Calculating APY yourself can be a math challenge, but fortunately you aren't typically called upon to do this. Just know that compound interest can raise the return on your account and enjoy the additional gains.