November 15, 2021

When people talk about comparing different savings accounts, you’ll often hear them tell you to look for whatever offers “the most interest.” Great — until you head to the pages of a few different account providers and find that they’re discussing APY instead. What does that even mean? How does interest rate vs. APY compare?

If you’re used to looking at borrowing accounts and seeing APR mentioned instead, you might be even more confused, but rest assured that each metric plays its own unique role. We’ll explain:

The difference between an interest rate and APY

How to calculate them

How to apply this to your personal finance decisions

Before understanding how interest rates and APYs differ, you’ll need to know what exactly APY is.

APY stands for annual percentage yield. The first clue here is the word “annual” — we’re talking about an amount of interest paid over a specific time frame, which allows for quick and easy comparisons.

If somebody told you they’d pay you an interest rate of 1% on your investment of $100, that isn’t very helpful. They could be paying you 1% on your balance every day, meaning you’d have $101 by the second day and $102.01 by the third day.

In contrast, if they were paying an annual rate, you’d have to wait a whole year to get your balance up to $101.

But there’s an even more important component at play: the power of compound interest. Most financial institutions don’t follow either of the models outlined above. Instead, they’re more likely to pay an annual interest rate but compound the interest on a monthly or quarterly basis.

To see why this matters, let’s take a look at the math.

You might recognize this formula from school:

APY = (1 + interest rate/N)^{N} - 1

The variable N is the number of compounding periods (i.e., if interest is paid quarterly, then there are four periods in a year).

Returning to the example above, we can use an APY formula to show the difference between an account that pays 1% in a year and one that pays 1% in a year where interest compounds monthly.

Inputting the relevant figures:

APY = (1 + 0.01/12)^{12} - 1 = 0.01005

In other words, the power of compounding periods transforms a 1% interest rate into a 1.005% APY. That might not sound like a big deal, but it starts to add up if you save larger sums of money over longer periods.

If you don’t fancy working this out manually, don’t worry — you can use an online APY calculator instead.

You might be thinking, “Well, in that case, APY means exactly what I thought interest rate meant.” There’s certainly some overlap — in some instances, the interest rate and APY for a bank account might be the same — but there are a few clear differences.

APY is a standardized measure that facilitates easy comparisons between two different accounts, which is perfect for helping you to save as much as possible. U.S. law requires banks to display their APY to avoid any kind of confusion.

This standardization is important since there’s so much variation over returns depending on the period interest is calculated over and the frequency at which compound interest is paid.

For example, let’s say you’re comparing two accounts, and both are advertising a 3% interest rate. However, one compounds monthly, so it has an APY of 3.04%, and the other compounds quarterly and has an APY of 3.03%. By comparing the APYs, you’re able to determine which account will earn more in interest.

Let’s pull all this together and look at how APY affects you as a saver and investor. After all, knowing the difference between these terms is about more than deciphering between them when you read the fine print.

As a saver, it’s important to get the best yield possible. In the examples we outlined above, APY showed a more favorable return than the simple interest rate. But is this always the case?

It’s true, most of the time. APY accounts for compounding interest, but simple interest doesn’t, and neither includes fees (like monthly account costs). So while there are exceptions, in most cases, APY comes out on top.

When it comes to savings accounts, the APY you can expect will be affected by the interest rate the Federal Reserve sets. The Fed raises interest rates to combat inflation (to encourage people to save more and borrow less) and does the opposite in times of recession. Financial institutions react to this by increasing or decreasing their rates in line with the Fed.

This impacts the APY you can earn.

Checking accounts usually offer a lower APY than a high-yield savings account or money market account. As of 2021, the average APY on an interest checking account is 0.03%, compared to 0.06% for a savings account and 0.08% for a money market account.

As for certificates of deposit (CDs), you can generally expect a higher APY since you have to lock your money away for longer. For a five-year CD, you can expect to earn an APY of 0.27% on average.

If the Fed were to increase interest rates, we can expect interest rates to increase roughly proportionately across these accounts. However, APY might not increase proportionately — this would depend partly on how frequently the interest compounds. (Also, remember that if you already have a CD open, your rate will be locked in for the period you signed up for.)

If these numbers sound low, bear in mind that these are averages.

Investment products aren’t directly affected by the Fed, and you can’t expect to earn a fixed APY from investments. Instead, your returns will depend on how an asset performs.

For example, if you’re putting money into an IRA and that IRA invests funds into the stock market, nobody can predict exactly how the stock market will perform. In the case of the S&P 500, its value decreased by 6.24% in 2018 and then increased by 28.88% in 2019.

While “rate of interest” is a more general term that can apply to saving or borrowing money, APY only refers to yields you earn from saving.

So, if you want to take out a credit card, personal loan, auto loan or another line of credit, it’s the annual percentage rate (APR) that you’ll need to look for.

For something like a credit card, APR and interest rate are often the same since there aren’t generally fees involved, whereas something like a mortgage has many other costs, so it’s important to focus on APR.

The bottom line is it pays to notice the small details. When you know your APY from your interest rates, you can pick the savings accounts that will accrue the most interest, giving you a healthier account balance and bringing you one step closer to achieving your financial goals.

But don’t stop there — there’s still so much more to learn. For more tips and tricks to improve your finances, join Tally’s email list, which will deliver financial resources straight to your inbox each week.