If you’ve ever poked around a bank’s website, we’re guessing you’ve probably seen “APY” somewhere in the fine print and wondered, What in the world is APY?
Well, the quick answer is that APY is an abbreviation for “annual percentage yield.” (Bankers love a good abbreviation almost as much as Twitter users.) That might sound super technical, but hang with us. We’re going to break down what APY is and give you everything else you need to know about it. We promise it won’t be TLDR. (That means “too long, didn’t read” for you non-Twitter users.)
What Is APY?
APY is usually a little bit higher than your account’s interest rate because it includes the interest you earn on your interest. For example, you might have a savings account with a 1% interest rate but a 1.01% APY.
Now, for most people, the little difference between their interest rate and APY adds up to just a few pennies. But when you talk about higher interest rates (say 10%), APY could be significantly higher than your simple interest rate because there’s more compound interest to earn interest on. (APY for a 10% interest rate is around 10.5%, by the way.)
So, how do you figure out APY in the first place? Well, banks use a pretty complex formula for calculating APY, so let’s take a look. (We’ll try to keep things simple.)
How to Calculate APY
If you want to know the APY for your savings account, you can usually find it somewhere in the fine print on your bank statement or on your bank’s website. But for those of you who like algebra, here’s the formula for calculating APY:
APY = (1 + r/n)n – 1
r = interest rate
n = number of compounding periods
To use this formula, you’ll need to find the number of compounding periods for your account. This is how often your bank pays interest and adds it to your account balance. Most banks do this daily or monthly. If it’s daily, the number of periods is 365. Monthly? Then it’s 12.
Let’s try an example. To keep things simple (sort of), we’ll go with a 5% interest rate with monthly compounding. You’ll end up with a formula like this that requires your old scientific calculator from high school to solve:
APY = (1 + .05/12)12 – 1
You take 5% (.05) divided by 12, then add 1 and take that number to the 12th power. Finally, subtract 1, move the decimal point two places—and boom. You’ve got your answer: 5.116%. If you changed the formula to daily compounding, you’d get 5.127%. From that, you can see that daily compounding leads to a little more money in your account.
At this point, you might be wondering, Is my savings account earning a good APY? Let’s see.
What’s the Average APY?
The average APY for savings accounts nationwide is 0.17%.1 That’s peanuts. Seriously, that’s just a little bit better than stuffing your cash under a mattress.
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If you shop around, though, you should be able to find a high-yield savings account or money market account with an APY in the 1.5% to 2% range. Certificates of deposit also usually have higher APY depending on the term. (The longer the term, the higher the rate.) But don’t tie up your money in a CD just for a couple of extra tenths of a percentage point in interest. The point of a savings account is to have a safe place for your money that gives you easy (but not too easy) access to it.
Keep in mind, interest rates change daily, so that’ll affect the APY on your savings account.
Is APY Variable?
APY can actually be fixed or variable. That just means the APY either stays the same (fixed) or changes over time (variable). Most savings and checking accounts have a variable APY. Your bank usually ties your interest rate to the federal funds rate—that’s just the rate that banks charge each other for short-term loans, The Federal Reserve sets the fed funds rate, so if the Fed raises rates (like it’s been doing lately), your APY should go up. And if the Fed cuts rates, your APY will fall.
Sometimes, a bank might try to attract business by offering a higher APY that’s fixed for new customers. These promotional rates might require you to have a certain number of deposits or transactions.
On the other hand, the APY for CDs is usually fixed. When you invest your money in a CD, it’s locked at the same interest rate for a specific amount of time (between three months and five years).
Federal law requires banks to tell their customers the APY and the compounding frequency for their accounts. Yep, it’s in the fine print, so make sure you read it. And if you’re already in the habit of reading financial fine print, you might have seen another abbreviation: APR.
APY vs. APR
APY and APR are similar but not the same. In simple terms, APR is interest you have to pay and APY is interest you get paid. APR stands for “annual percentage rate,” and it’s the percentage you’ll pay in interest and fees on a loan. This could be a car loan, a credit card, a mortgage or a student loan. And unlike APY, APR doesn’t include compound interest.
For credit cards, APR and the interest rate are usually the same percentage because you don’t pay fees to open a credit card.
On the other hand, a mortgage will usually have fees or other charges, so your APR could be slightly higher than your interest rate. If you check mortgage rates online, you’ll usually see an interest rate and an APR listed for each loan type.
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