How APY Works and How It’s Different From APR

APY — which stands for annual percentage yield — is the percentage of your money that you can earn back in interest when you deposit it at a financial institution. Unlike APR, which shows how much interest you’ll pay annually for a credit card or loan, APY factors in compounding interest.

If you’re comparing savings accounts or money market accounts, choosing a financial institution with a competitive APY will maximize the interest you earn. In this article, we’ll explain what is APY and how to calculate APY.

What Is APY?

APY is short for annual percentage yield and shows how much interest you can earn when you deposit money at a bank or financial institution. Another term for APY is earned annual rate, or EAR. You’ll see APYs advertised when you compare rates for deposit accounts, such as:

The APY on most bank accounts is variable, meaning that it can change at any time. One exception is CDs, which typically pay a fixed rate until the CD reaches its maturity.

APYs are tied to the benchmark interest rates set by the Federal Reserve. If the Fed raises interest rates, most banks will pay more interest to stay competitive. But if the Fed lowers interest rates, your APY would drop.

How to Calculate APY

APY is calculated using the following formula:

A=P(1+[r/n])^rt

A = Future value of both initial principal and interest earned

P = Initial principal amount, or beginning deposit

r = Annual interest rate, expressed as a decimal

n = Number of compounding periods in a year

t = Time in years

As an example, suppose you open a new high-yield savings account at an online bank that offers a 2% APY. You deposit $10,000 and don’t make any withdrawals or additional deposits for a year. Interest is compounded monthly. You’d calculate APY as follows:

$10,000(1+[0.02/12])0.02(1) = $10,201.84

What Is the Average APY?

The average APY varies by the type of deposit account. As of March 2022, the average savings account APY was 0.06%, though the best high-yield savings accounts pay as much as 0.5% or 0.6%.

Before the pandemic, APYs as high as 2% weren’t uncommon. But when the Fed slashed interest rates to nearly zero as part of its emergency COVID-19 response, APYs also tanked. The Fed increased interest rates by 0.25% in March 2022, its first rate hike since December 2018. As inflation soars, more increases are likely ahead, which should eventually cause APYs to rise.

How to Get the Best APY

• Open a high-yield savings account or money market account. Checking accounts have extremely low APYs. Many don’t pay any interest at all. High-yield savings accounts and money market accounts offer much higher APYs, making them a good place to keep money you don’t need for bills and day-to-day spending.

• Use an online bank. Because they have lower overhead expenses, online banks typically offer higher APYs than traditional brick-and-mortar financial institutions. You may also get a better APY if you switch to a credit union.

• Keep saving. Many banks use a tiered approach to APYs, giving a better APY to accounts with higher balances. As you build your savings, you may qualify for higher rates.

• Choose longer CD terms. CD terms range from one month to five years. CD rates are highest when you choose longer terms. Keep in mind, though, that early withdrawal penalties typically apply. Also, because CDs pay a fixed rate, you could still find yourself locked into a below-market rate if you choose a longer-term CD and interest rates rise. For that reason, a CD ladder is often a better strategy than simply choosing a five-year CD with the highest annual percentage yield.

What Is Annual Percentage Rate (APR)?

Annual percentage rate, or APR, shows you the cost of borrowing money, expressed as a percentage of the amount borrowed. You’ll see APRs advertised when you’re shopping for a credit card, mortgage or personal loan. If you took out a loan with a 10% APR, that means that every $1,000 borrowed would cost you $100 over a year.

Because APR includes costs like origination fees and closing costs, it gives you a more accurate estimate of the cost of borrowing than the interest rate alone.

APR vs. APY: What’s the Difference?

APR and APY are two different ways of calculating an annual interest rate. APY shows how much interest you can earn in a deposit account in a year, while APR shows how much you’ll pay to borrow money

The big difference between APR vs. APY boils down to compound interest. APR measures simple interest and doesn’t account for compounding. But APY includes compound interest, which is interest paid on interest.

Both APR and APY can be fixed or variable. Mortgages and loans typically have a fixed APR, while credit cards and lines of credit usually have variable APRs. Variable APYs are the norm with bank accounts, but CDs often pay a fixed interest rate.

As a consumer, you want a higher APY when you’re shopping for a deposit account because that means more interest earned on your principal balance. But you want the lowest APR when you’re shopping for credit because that means you’ll pay less money in interest.

Frequently Asked Questions (FAQs)

Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected] or chat with her in The Penny Hoarder Community. 

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