Annual Percentage Yield (APY) is an important concept for savers and investors to understand when shopping for bank accounts or other interest-bearing financial products. APY represents the total amount of interest earned on an account over one year, factoring in the effect of compound interest.
What is the Definition of APY?
APY stands for Annual Percentage Yield. It is defined as the effective annual interest rate earned on an account after factoring in the effect of compounding over a year.
In other words, APY shows the total amount of interest that will be earned on a deposit account over the course of one year. It assumes that interest earned remains in the account and compounds.
How is APY Different from Interest Rate?
APY differs from the basic interest rate in that it takes compounding into account, while the interest rate does not. For example, let’s say you have a savings account with a 2% interest rate. This means you’ll earn 2% interest on the principal deposit each year.
But if interest is compounded monthly, the APY would be slightly higher at 2.04%. This means that in one year, you’ll earn 2.04% of your total funds, including interest earned and interest left to compound.
The more frequently interest compounds, the higher the APY will be compared to the stated interest rate.
READ ALSO: A Beginner’s Guide to Interest Rates
The formula used to calculate APY based on interest rate and compounding frequency is:
APY = (1 + r/n)^(n) – 1
r = stated annual interest rate
n = number of compounding periods per year
For example, if a savings account pays 3% interest compounded monthly:
r = 0.03
n = 12 (for monthly compounding)
Plugging this into the formula:
APY = (1 + 0.03/12)^(12) – 1
APY = 0.0305 or 3.05%
So while the interest rate is 3%, the APY is slightly higher at 3.05% due to monthly compounding.
Why is APY Important?
There are a few key reasons why APY is an important concept for savers and investors:
- Comparing returns – APY allows you to accurately compare returns between different financial products. Comparing basic interest rates does not account for differences in compounding frequency.
- Estimating earnings – Knowing the APY makes it easy to estimate total earnings over a year using online calculators or spreadsheets.
- Maximizing earnings – Products with higher APYs will earn more interest over time, so savers should seek accounts with the highest APY within their risk tolerance.
- Required disclosure – Banks and credit unions are required by law to disclose APY rates on deposit accounts like savings, checking, CDs and money market accounts.
Factors That Affect APY
Several factors determine the APY earned on a bank account or financial product:
- Interest rate – The underlying interest rate is the baseline for determining APY. A higher interest rate means higher APY.
- Compounding frequency – More frequent compounding (daily, monthly) results in higher APY than less frequent compounding (quarterly, annually).
- Account term – Longer-term products like 5-year CDs generally have higher APYs than short-term products like 1-year CDs.
- Account balance – Some banks offer “tiered” APY structures where higher balances earn higher rates.
- Deposit activity – For savings accounts, maintaining a certain deposit level each month may be required to earn the advertised APY.
- Benchmark rates – APYs on variable-rate products often fluctuate based on indexes like the federal funds rate.
Comparing Bank Account APYs
When comparing APYs on bank accounts, make sure to consider:
- Minimum balance requirements
- Qualifications to earn advertised APY
- Fees that may reduce earnings
- Accessibility of funds (withdrawal limits)
Don’t sacrifice important features just to earn a slightly higher APY. Make sure the account aligns with your needs.
APY on Savings Accounts
The average APY on savings accounts at brick-and-mortar banks is around 0.10%, while top online banks offer over 4% APY. The highest rates are typically found at online banks due to lower overhead costs.
Look for a high-yield savings account with no minimum balance and easy access to your funds. Aim for an established bank with FDIC insurance on deposits.
APY on CDs
Certificate of Deposit (CD) terms can range from 3 months to 5 years, with longer terms earning higher APYs generally. The average 1-year CD rate is around 1.50% APY currently, while 5-year CDs may offer over 3.00% APY.
Be sure to consider early withdrawal penalties when committing funds to a long CD term. Look for “bump up” CDs that allow you to increase your rate once.
APY on Checking Accounts
Interest-earning checking accounts offer very low APYs at traditional banks, usually around 0.01%. Online banks sometimes offer high-yield checking accounts with up to 0.50% APY.
Consider fees, transaction limits and other factors when comparing checking account APYs. You may sacrifice convenience for negligible interest earnings.
APY on Money Market Accounts
Money market accounts can earn significantly higher yields than savings accounts. Top rates are currently around 3% APY or more. Money market accounts typically have higher minimum balances and limited transactions.
Compare MMA fees and restrictions to ensure the account aligns with your needs. Online banks tend to offer the most competitive MMA APYs.
How Does Compounding Frequency Affect APY?
Compounding frequency directly impacts APY earned. The more interest is compounded, the higher the effective annual yield.
For example, let’s look at a savings account with 2% interest:
- 2.00% APY with annual compounding
- 2.02% APY with quarterly compounding
- 2.04% APY with monthly compounding
- 2.04% APY with daily compounding
All else being equal, choose accounts with more frequent compounding. But also consider other factors, like the minimum balance and fees.
How Do Federal Reserve Rates Impact APYs?
The Federal Reserve’s federal funds rate indirectly impacts deposit account APYs. When the Fed raises or lowers rates, banks typically adjust their own rates accordingly.
For example, if the Fed boosts rates by 0.50%, savings account and CD rates at banks may also increase by around 0.50% or more. Rate hikes lead to higher yields for savers.
Is APY Ever Guaranteed?
For fixed-rate accounts like certificates of deposit, the APY is guaranteed for the term of the CD. But for variable-rate accounts, the APY is never guaranteed long-term.
Banks can change the interest rates (and thus APYs) on products like savings, checking and money market accounts at any time. But significant rate changes don’t happen frequently on well-managed accounts.
How Often Does APY Change?
APY changes are more common on variable-rate accounts. Savings and money market account APYs fluctuate somewhat regularly based on markets. Checking account APYs change less frequently but can still be adjusted by banks.
Fixed CD terms lock in the APY for the contract period. Upon renewal, your APY will adjust to the current market rates. So APY changes happen infrequently for CD products.
Which Accounts Have Variable APYs?
These types of bank accounts will typically have variable APYs:
- Savings accounts
- Money market accounts
- Interest checking accounts
- Credit union share accounts
The APYs on these products can change at any time at the discretion of the bank or credit union. They tend to fluctuate based on factors like the federal funds rate.
Which Accounts Have Fixed APYs?
Fixed interest rates and APYs are commonly offered on:
- Certificates of deposit
- Term share certificates at credit unions
- Some specialty savings accounts
For these accounts, the APY is set for the term and guaranteed by the bank upon account opening. Make sure to review early withdrawal penalties before opening a fixed-rate account.
How to Find the Best APY Rates
Finding accounts with top APY rates takes some research, but it can really pay off over time. Here are some tips:
- Check online banks, which tend to offer higher yields than brick-and-mortar banks
- Compare APY along with fees, balance requirements, etc.
- Look for high-yield and rewards checking if you want interest from your checking account
- Consider longer CD terms (2 years or more) for higher fixed APY
- See if credit unions offer competitive APYs on savings and certificates
- Use APY comparison sites like Bankrate.com to survey the market
How Much Interest Can You Earn with Different APYs?
The amount of interest you earn depends on the APY, your account balance, compounding frequency, and how long you maintain the account. Let’s look at potential earnings with sample APYs:
This is a typical savings account rate at brick-and-mortar banks. With a $10,000 balance compounding monthly, you’d earn only $10.47 in interest after 1 year.
Online banks offer savings accounts in this range. With a $10,000 balance compounding daily, your earnings after 1 year would be $50.23.
Top online savings and money market accounts can offer 1% or more. On a $20,000 balance compounding daily, you’d earn $201.01 in your first year.
High-yield and rewards checking accounts sometimes pay up to 2% APY. Maintaining a $15,000 balance would net you $304.34 in your first year.
The top 5-year CD rates are currently around 3% APY. With interest compounding monthly, you’d earn $3,045.34 on a $100,000 CD balance after 5 years.
Some online banks offer savings and money market yields above 4% APY. On a $50,000 balance compounding daily, you could earn over $2,000 in your first year.
APY vs. APR: What’s the Difference?
APY and APR sound similar, but they are distinct terms:
- APY – Annual Percentage Yield earned on bank account interest
- APR – Annual Percentage Rate charged on credit products like loans and credit cards
The main difference is that APY refers to interest earned by the consumer, while APR refers to interest paid by the consumer.
You want to maximize APY when opening deposit accounts to earn the most interest possible. In contrast, you want to minimize APR when taking out loans to pay the lowest amount of interest possible.
So APY is good for savers, while APR is bad for borrowers. This helps explain why the two acronyms should never be used interchangeably.
The Bottom Line
Understanding APY is key to maximizing earnings on bank accounts and financial products. Seek accounts advertising higher APYs when possible, focusing on reputable banks and credit unions.
Use APY, along with other factors like fees and accessibility, to choose deposit accounts that meet your needs. Take the time to shop around for the most favorable interest rates and lock in the highest yields.
Common Questions about APY
What is a good APY?
A good APY depends on the type of bank account. For savings accounts, a good APY is around 1% or higher. For CDs, aim for at least 2% APY on shorter terms. Money market and checking account APYs above 0.50% are decent.
How often do APYs change?
APYs change somewhat regularly for variable-rate accounts when banks adjust their rates. Fixed-rate CD terms lock in the APY for the contract period. Upon renewal, CD APYs can be adjusted.
Can you negotiate an APY?
Unfortunately, the APY rates on standard deposit accounts are non-negotiable. However, you may be able to negotiate CD rates for very large balances ($100,000+).
Do credit unions offer good APYs?
Yes, credit unions are non-profit and member-owned, so they often offer very competitive savings/certificate APYs compared to banks. However, you need to become a member first.
How often does interest compound?
Common compounding frequencies are daily, monthly, quarterly and annually. Online banks often compound interest daily, which results in slightly higher APY.
Can the APY ever change during the CD term?
No, the APY on a CD is fixed for the term once the CD is opened. But upon renewal, the rate can be changed to reflect market conditions.
In another related article, What’s the Average Personal Loan Interest Rate?
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