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What Is APY?

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If you've ever opened up a savings account, interest-bearing checking account, money market account, or a certificate of deposit (CD), you've probably heard of the term APY. A lot of people could probably tell you that a higher APY is better than a lower one, but when asked directly "What is APY on a savings account?", most people draw a blank.

It might sound like a complicated concept, but it isn't too difficult to understand. Here's a primer on APY and what it means for your deposit accounts.

What is APY in banking?

APY stands for annual percentage yield. It's the standard way for a financial institution to describe the returns you can earn on your savings, CD, or interest-bearing checking account. It tells you how much your balance will grow if you leave it in your account for one year.

For example, if you have a $1,000 savings account balance with a 1% APY, it will grow by 1%, or $10, in one year. This assumes your APY and your balance remain the same over that time, which isn't always the case. But that gives you a basic understanding of what the APY formula is trying to tell you.

APY vs. interest rate

People often use APY and interest rate interchangeably, but they're actually not the same. Interest rate is a part of the APY formula, but APY also takes into account how often your savings compounds. The formula for calculating it is this:

APY = (1 + Interest Rate/Compounding Period)Compounding Period- 1

Compounding periods refers to how frequently you earn interest on your balance. A higher number is better in this case. Savings accounts usually compound daily or monthly. At first, you only earn interest on your principal balance. But the next day or month, you earn interest on your initial balance plus whatever interest you've earned so far. This is what is known as compounding interest.

If you have an account with a 1% interest rate that compounds monthly, the APY would actually be about 1.005%. APYs are usually slightly higher than interest rates, but the two tend to hang pretty close together.

Banks use APY over interest rates when advertising their bank accounts because APY gives you a more accurate idea of how much you'll earn over time. Let's say you were lucky enough to find two savings accounts that both offered 5% interest rates (hey, we can dream). If one compounds monthly, its APY would be about 5.12%. But if the other compounds daily, its APY would be about 5.13%. The difference is slight, but if you deposited $1,000 into each of these two accounts, you’d earn about $0.10 more with the one that compounded daily than the one that compounded monthly, even though they both had the same interest rate.

The long-term compounding power of APY

APY and compound interest aren't going to turn your pocket change into thousands of dollars overnight. But with enough time, they can make a big difference in the value of your savings.

Let's say you open a $10,000 CD with a five-year term and a 4% APY. Here's how your account balance would look over time:

Year Starting Balance Interest Earned Ending Balance
1 $10,000.00 $400.00 $10,400.00
2 $10,400.00 $416.00 $10,816.00
3 $10,816.00 $432.64 $11,248.64
4 $11,248.64 $449.95 $11,698.59
5 $11,698.59 $467.94 $12,166.53
Data source: Author's calculations.

Each year, your APY is applied to a larger balance and that helps you grow your savings by 21.7% over those five years.

How savings account APY changes over time

All of the above examples have assumed that your APY remains the same for the entire time period we're looking at. That is the case with a lot of CDs, which lock in your rate for the full term. But for savings accounts and interest-bearing checking accounts, APY can change at any time.

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They tend to rise and fall depending on what other benchmarks, like the prime rate, are doing. When the prime rate falls, bank account APYs tend to fall too, and when the prime rate rises, you may see your savings account’s APY climb as well. Of course, this is only a general rule of thumb. It's up to each bank to set its own rates and decide how often to change them.

Finding the best APY for your savings

APYs vary widely by account and by bank. Brick-and-mortar banks tend to offer much lower APYs than online savings accounts because they have to spend a lot of their cash maintaining their branches. Online banks don't have to do this, so they can charge you fewer fees and offer you a high-yield savings account with a better APY.

There are other features to consider besides APY when choosing a savings account, like customer service and how easy it is to access your funds, but APY should definitely be one of your deciding factors. As the above examples show, it can make a huge difference in how fast your savings grow.

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