APY vs. Interest Rate: What’s the Difference? | Banking Advice
Key Takeaways
- APY stands for annual percentage yield, which provides a full picture of how much interest you can earn on savings over one year.
- APY includes compound interest, or “interest on interest.”
- Interest might be compounded daily, monthly or quarterly.
The APY and the interest rate are two key figures to know when storing money in a savings account or other interest-earning bank account.
Both are expressed as percentages, but an account’s APY gives you the full picture of how much interest you can earn on your money.
What Is an Interest Rate?
An interest rate is the amount of money – expressed as a percentage, such as 3.5% – that a bank or credit union pays you to use the money you’ve deposited.
Banks and credit unions set interest rates for savings and other deposit accounts, which are influenced by the benchmark rates set by the Federal Reserve.
How Is it Calculated?
Calculating interest on a savings account for a single period is fairly straightforward. The formula for calculating simple interest is A = P x R x T.
- A is the amount of interest you’ll wind up with.
- P is the principal or initial deposit.
- R is the annual interest rate (shown in decimal format).
- T is the number of years.
Let’s say your account balance is $10,000 and you don’t deposit any more money into the account.
When you multiply the interest rate by the balance in a bank account, you come up with the basic interest rate. If the interest rate is 3.50% and compounds yearly, the total interest you’d accumulate after one year would be $350, giving you a balance of $10,350.
What Is APY?
An account’s APY includes compound interest, or “interest on interest.” All banks pay compound interest. This represents the total interest you earn both on the funds you’ve deposited and the interest you’ve gained in previous cycles. So, the higher the APY is on a bank or credit union account, the more interest you stand to gain.
Banks and credit unions generally display account APYs on their websites, advertisements and marketing materials. This information enables savers to an apples-to-apples comparison of how much interest they stand to earn across various financial products and institutions.
How Is it Calculated?
Since APY includes compound interest, the calculations are a bit more complicated than the basic interest rate. The formula for calculating compound interest is A = P(1 + r/n)^nt.
- A is the amount of money you’ll wind up with.
- P is the principal or initial deposit.
- r is the annual interest rate (shown in decimal format).
- n is the number of times the interest compounds in a year.
- t is the number of years.
Let’s look at the same bank account with $10,000 but if the interest compounds daily.
10,356.18 = 10,000(1 + .035/365)^365×1
If you don’t add to or withdraw from that pot of money and the interest rate stays at 3.50%, you will have earned $356.18 in interest for an end balance of $10,356.18; an extra $6.18 compared to an account that doesn’t compound over the course of the year. This is because you’ll have earned interest on those little bits of interest that have been applied to the balance throughout the year, in addition to the starting balance.
What Is the Difference Between APY and Interest Rate?
The interest rate is the percentage of interest applied to your balance during a certain period, such as each day or each month. APY represents the total interest you can expect to earn over a year by factoring in how frequently the interest compounds.
You can use a savings calculator to determine how much your balance will grow based on your account’s APY. The table below shows how different compounding rates would affect savings over 10 years if the interest rate is 3.50% and the starting principle is $10,000.
| Compounding Rate | Balance After 1 Year | Balance After 10 Years |
| No compounding | $10,350.00 | $13,500.00 |
| Yearly | $10,350.00 | $14,105.99 |
| Quarterly | $10,354.62 | $14,169.09 |
| Monthly | $10,355.67 | $14,183.45 |
| Daily | $10,356.18 | $14,190.44 |
When you’re looking for a place to park your savings, skip the basic interest rate and look at the APY. Because it includes compound interest, the APY provides the broader picture of how much interest you can expect to earn.
What to Look for When Shopping for Savings Accounts
While the APY and interest rate are important factors in choosing a savings account, you should also look at:
- Minimum deposit. Would you be required to make a minimum deposit to open a savings account that you’re eyeing? A minimum deposit might not be a dealbreaker unless the amount of the initial deposit is high. Your best bet: Search for a savings account with no minimum initial deposit.
- Minimum balance. Would you be required to keep a certain amount of money in your account? In some cases, a financial institution might demand that you maintain a minimum balance to score the best interest rates. If possible, select a savings account with no minimum balance requirement.
- Compounding rate. Does the interest compound daily, monthly or quarterly? More frequent compounding is more beneficial to you.
- Fees. Would you end up paying a bunch of fees that would eat into the interest that you’d earned? Ideally, you should pick a savings account with low or no fees.
- ATMs. If a savings account provides an ATM card, how much access would you have to fee-free ATMs in the bank’s or credit union’s network?
- Branches. Are you OK doing business solely online? Or do you want to be able to visit a physical branch? The answer to these questions may help determine which savings account you pick.
- Customer service. What is the bank’s or credit union’s reputation for providing good (or bad) customer service?
