APY — short for “annual percentage yield” — is one of the most important numbers you’ll see when shopping for a bank account. It reveals how much you’ll truly earn in one year after compound interest is factored in.
Understanding APY can help you spot better savings opportunities and make smarter decisions about where to park your cash. Here’s what you need to know about what APY means, how it works, and how to compare accounts with various APYs.
Annual percentage yield — or APY — represents how much money you’ll earn on your bank account balance over one year when considering the effect of compounding interest.
In other words, APY shows your true rate of return. While a simple interest rate only reflects the base rate a bank pays, APY factors in how often interest is added to your balance, whether it’s daily, monthly, or annually. The more frequently interest compounds, the higher the APY will be, even if the stated interest rate stays the same.
You’ll usually see APY quoted for checking accounts, savings accounts (including high-yield savings accounts), money market accounts, and certificates of deposit (CDs). It’s the best number to use when comparing deposit accounts, because it lets you see which option will grow your money faster over time.
For example, let’s say you deposit $10,000 into a savings account that earns a base rate of 1.24%. You might expect to earn $124 over the course of a year, bringing your balance to $10,124.
However, interest compounds daily, meaning the interest you earn is added to your balance every day and it starts earning interest too. So, your true earning rate is 1.25% APY. As a result, your $10,000 actually earns about $125 over the year, leaving you with $10,125 instead. The difference may seem small in this case — just $1 — but it adds up over time, especially with higher balances or better rates.
Read more: APY vs. interest rate: What’s the difference?
Calculating APY can be helpful when you compare accounts with different APYs or compounding schedules. Typically, however, you won’t need to calculate the APY; the bank or credit union will do it for you.
The formula for APY is:
APY = (1 + r/n)^n – 1
r = interest rate
n = number of compound periods in one year. If your account compounds monthly, for example, n=12.
If the interest rate of your account is 2%, which would be represented as .02, and it compounds monthly, the formula would look like this:
APY = (1 + .02/12)^12 – 1
Once you multiply the result by 100 to get a percentage, your APY would equal 2%. If you’d rather not do the math, you can use a compound interest calculator to determine how your money would grow over time.
The main difference between APY and APR (which stands for annual percentage rate) is that APY is how much interest an account will earn in a year, while APR is how much it will cost you to repay money you’ve borrowed.
Let’s say you take out a car loan. The APR equals your yearly cost — including interest and fees — to repay the loan. With a credit card, the APR doesn’t include fees, but it does tell you how much interest you’ll be charged if you don’t pay off the balance in full.
A higher APY is better because you’ll earn more interest on the money you save. A lower APR is better because it will be cheaper to repay the borrowed money.
Whether your APY is fixed, meaning it doesn’t change, or variable — fluctuates based on the economy and the bank’s policies — depends on the type of account you opened. Many savings accounts, for example, have a variable APY, while the APY on most CDs is fixed.
Read more: Fixed rate vs. variable rate: What’s the difference, and why is it important?
A good starting point to compare APYs is the national average savings rate of about 0.39%. That doesn’t mean you should settle for that rate. Many online banks offer high-yield savings accounts and CDs with APYs that are 10 or more times higher.
Online banks and credit unions typically offer much higher APYs than large, brick-and-mortar banks because it’s less expensive for them to operate. Just be sure the account meets your needs for how you like to bank, such as having ATM access or 24/7 customer service. Beyond that, the best account for growing your money is one with a high APY and low fees.
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