In this article:
Annual percentage yields (APYs) and interest rates can tell you how much you might earn from depositing money into an interest-bearing account, such as a savings or money market account. But they're not the same thing. The APY includes compounding and can give you a better understanding of how much you'll earn each year, which is why financial institutions have to use APYs when describing their deposit accounts.
| APY vs. Interest Rate | ||
|---|---|---|
| Annual Percentage Yield (APY) | Interest Rate | |
| The interest earnings from depositing money | Yes | Yes |
| The cost of borrowing money | No | Yes |
| Includes compounding | Yes | No |
What Is APY?
An account's APY takes the account's interest rate and compounding into consideration to help you understand how much interest you can earn over a year. For example, if you deposit and keep $100 in a high-yield savings account with a 5% APY, you will earn $5 over the year.
Certificates of deposit (CDs) tend to offer a fixed APY for a specific term, and comparing CDs' APYs can help you identify which account will net you the most earnings.
Find High-Yield CDs
The APYs on savings and money market accounts can also be helpful. However, your actual earnings will depend on whether you withdraw or deposit money into the account. Changing federal interest rates can also lead banks to lower or increase the interest rate on your savings account, which will affect its APY and your earnings.
What Is Interest?
Interest is the cost of borrowing money. When you deposit money in an interest-bearing account, the financial institution pays you interest to use your money. Alternatively, you'll have to pay interest if you borrow money from a lender, like for a mortgage.
Interest can be applied as simple interest or compound interest. With simple interest, the interest rate only applies to the principal balance—the amount deposited or borrowed. But when an account uses compound interest, the interest rate applies to the principal balance and any outstanding interest.
APY vs. Interest Rate Example
If an account uses simple interest, the interest rate and APY will be the same. However, if interest compounds, the APY will be higher than the interest rate.
Consider a CD that has a 5% interest rate and a one-year term. If the interest compounds monthly, one-twelfth of the interest rate gets multiplied by the principal balance each month. The interest is added to the principal balance, leading to more interest earnings the next month.
Here's what that looks like with a $1,000 CD.
| APY Example: $1,000 CD With 5% Rate | ||
|---|---|---|
| Month | Interest Earned | Ending Balance |
| 1 | $4.17 | $1,004.17 |
| 2 | $4.18 | $1,008.35 |
| 3 | $4.20 | $1,012.55 |
| … | … | … |
| 12 | $4.36 | $1,051.16 |
The CD has a 5.12% APY—you earn $51.16 on your $1,000 deposit over the year. If the interest didn't compound, you would only earn $50 of interest and the interest rate and APY would both be 5%. You'll see the APY, not the interest rate, when searching CD rates.
Which One Is More Important to Know for Savings Accounts?
It can be useful to understand how interest rates and compounding affect an account's APY, but the APY is ultimately the more important number. After all, the APY takes the interest rate into consideration.
If you want to, you could use a compound interest calculator to find an account's APY. But regulators generally require banks and credit unions that advertise a rate on a deposit account to use the account's APY anyway. So, it's often easy to compare APYs to determine which account pays the most interest.
Savings calculator
†The information provided is for educational purposes only and should not be construed as financial advice. Experian cannot guarantee the accuracy of the results provided. Your lender may charge other fees which have not been factored in this calculation. These results, based on the information provided by you, represent an estimate and you should consult your own financial advisor regarding your particular needs.
Try the full Savings Calculator Opens a new window with more features.
The Bottom Line
No matter what type of compounding your savings account uses, the important thing is you're stashing away cash that's earning money for you. Having a clear savings strategy—as well as goals for that savings—can help you slowly build your savings so you can reach your financial goals without taking on additional debt. Whether you're looking to build an emergency fund for a rainy day or planning a month-long overseas trip, it's a good feeling knowing you've got money ready when you need it.