You've probably heard the term APY when opening up a savings account, interest-bearing checking account, money market account, or a certificate of deposit (CD). It's common knowledge that a higher APY is better than a lower one, but when asked "What is APY?", most people draw a blank.
It's actually pretty simple. Here's a short primer on APY and how it boosts your bank accounts.
What is annual percentage yield (APY) in banking?
APY stands for annual percentage yield, or how much your balance grows each year. 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.
Example: Say you have a $1,000 savings account balance with a 1% APY. In one year, it will grow by $10. This assumes your APY and your balance remain steady, which isn't always the case. But APY gives you a basic understanding of how much you could earn in one year.
APY vs. interest rate
People often use APY and interest rate interchangeably, but they're different. Interest rate is a part of the APY formula, but APY also takes into account how often your savings compounds. The formula for calculating APY is this:
APY = (1 + Interest Rate/Compounding Period)^Compounding Period − 1
Interest rate: The annual interest rate, usually as a decimal.
Compounding period: The number of times the interest is compounded per year.
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 they're typically close.
When advertising, banks use APY instead of interest rates because APY gives you a more accurate idea of how much you'll earn over time.
Let's say you're lucky enough to find two savings accounts that both offer 5% interest rates. One compounds monthly: its APY is about 5.12%. But if the other compounds daily: its APY is about 5.13%. If you deposited $1,000 into each account, you'd earn about $0.10 more with the one that compounds daily, even though they both have the same interest rate.
The long-term compounding power of APY
APY and compound interest aren't going to turn pocket change into thousands of dollars overnight. But with enough time, they crank up 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 grow over time: