The content of this article is provided for informational purposes only. You should always obtain your own independent, tax, financial, and legal advice before making any material decision.
An account’s annual percentage yield (APY) showcases how much interest is earned over a year. When planning finances and setting savings goals, it’s a key to understanding how much can be earned on savings over time.
Financial institutions advertise the APYs on deposit accounts, including checking, savings, and money market accounts.
Comparing APYs can be important for determining which account will likely pay out the most interest. Learn the ins and outs of APY in this guide.
An APY tells someone how much interest they could earn if they keep their money in an account for a year. For example, an account with a 3% APY pays $3 in interest every year for every $100 kept in the account.
The actual amount of interest someone earns may depend on whether they deposit or withdraw money. Many checking and savings accounts also have a variable APY, meaning the interest rate can change throughout the year.
Generally, accounts with a high APY pay more interest than accounts with a low APY.
Two factors determine an account’s APY:
The APY calculation can be difficult to do by hand. However, there are many online APY calculators available.
People looking for a new bank account usually don’t need to calculate the APY on their own. The Truth in Savings Act (TISA) requires covered financial institutions to disclose the APY on advertisements for checking accounts, savings accounts, money market accounts, and CDs that show a rate of return.1
The difference between an account’s APY and its interest rate is compounding.
An account’s interest rate tells someone how much interest that account pays each compounding period. However, it doesn’t specify how frequently the interest compounds.
For example, an account with a 5% interest rate pays $50 of interest for every $1,000 in the account. If the interest never compounds, the account pays out $50 over the entire year.
However, if the interest compounds monthly, the account holder earns one-twelfth of the interest each month. They also earn interest on their interest.
For example, $4.17 is $50 divided by 12, so the account holder earns $4.17 at the end of the first month. The $4.17 gets added to the $1,000, and now the 5% interest rate applies to the larger $1,004.17 balance at the end of the second month.
By the end of the year, the person earns $51.16 instead of $50. The account’s APY is 5.12% compared to its 5% interest rate. The 5.12% better reflects how much interest the account paid over the year.
Because APY includes compounding, it’s helpful to compare accounts’ APYs when looking for a place to keep money that’s set aside for short- and medium-term goals, such as an emergency fund.
PayPal Savings compounds interest daily and pays out the interest that accrues throughout the month at the end of each month.2
APY is also distinct from the annual percentage rate (APR), which is the annualized rate that someone pays when borrowing money.
Similar to how APY may be more helpful than interest rates when comparing places to keep savings, accounts’ APRs may be more helpful than their interest rates when comparing loan offers.
A loan’s interest rate only tells the borrower how much interest accrues on the money they borrow. But many types of loans have fees, such as an origination fee that someone must pay when they first accept the loan. APR doesn’t include compounding, but it does include certain required fees to help people better understand their total cost of borrowing.
Ultimately, APY is for money being saved or invested, while APR is for borrowed money.
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