When looking at deposit services, like savings accounts and certificates of deposits, you are likely seeing terms like Annual Percentage Yield (APY) and interest rate. These two terms mean the same thing, right? Not quite, but they are similar.

Knowing the difference between the two can help you understand your expected return on deposits and investments. Here’s what you need to know.

What is interest rate?

An interest rate on a checking or savings account is the percentage that a financial institution pays to depositors for keeping their money in that account. This percentage doesn’t account for compounding.

What is APY?

APY provides the actual annual return on an investment or interest-bearing deposit account (such as a checking or savings account), taking into account the effect of compounding interest. It provides a more accurate picture of how much interest you will earn in a year compared to calculations based only on interest rate.

APY takes into account both interest and the frequency at which it compounds. After depositing funds into your account, you earn interest at set intervals of time (daily, monthly, quarterly, etc.) and that interest is added to your balance. After your interest is added, it begins compounding, meaning you are earning interest on the interest you have already earned.

APY can help you compare the earnings potential of different financial products more accurately than interest rates alone. The higher the APY, the faster your money will grow.

How APY is calculated

The formula for calculating APY is:

APY = ( 1 + r/n )ⁿ – 1

where r is the interest rate and n is the number of compounding periods per year.

For example, if a savings account offers a nominal interest rate of 5% compounded monthly, the APY would be:

APY = ( 1 + 0.05/12 )¹² – 1 = 5.12%

Key Differences Between APY and Interest Rate

Compounding Frequency:

• Interest Rate: Does not account for how often interest is added to the principal (compounded).
• APY: Takes into account the frequency of compounding, providing a more accurate measure of yearly earnings.

Real Earnings/Costs:

• Interest Rate: Provides a basic measure of the annual growth or cost without considering compounding.
• APY: Reflects the actual growth or cost, including the impact of compounding, making it a better indicator of the true return or expense.

Shopping for a savings tool

For consumers, understanding the difference between APY and interest rate can lead to better financial decisions. When comparing savings accounts or investment products, looking at the APY will give a clearer picture of potential earnings.

Example of how knowing APY can impact your decision

Imagine you’re choosing between two savings accounts:

• Account A offers a 5% interest rate compounded annually (APY of 5%).
• Account B offers a 4.9% interest rate compounded monthly.

At first glance, Account A seems better due to the higher interest rate. However, calculating the APY for Account B reveals:

APY = (1+0.049/12)¹²-1
APY = (1.004083)¹²-1
APY = (1.050111)-1
APY ≈ 0.0501 or 5.01%

Despite the lower interest rate, Account B’s APY is higher due to more frequent compounding, making it the better option for maximizing returns.

Savings made easy

When you’re ready to find the right savings vehicle for your needs, use your understanding of APY vs. interest rate to pick the right one for you. Comparing APYs rather than interest rates will help you make the best decision for your savings.

If you are looking for a high-yield savings account that allows your money to grow quickly without the hassle, check out Panacea Financial’s High-Yield Savings Account. Open your account in minutes and find our current APY here.