Table of Contents
- APY (annual percentage yield) is your account’s rate of return based on interest and compounded gains set over a period of time.
- APYs can be fixed for a set period of time or variable, meaning that they are subject to change based on market conditions.
- There are several account types that provide APY rates including savings accounts, high-yield savings accounts, certificates of deposit, and cash management accounts.
- The best APY account depends on your individual financial needs and situation.
Introduction to APY
APY stands for Annual Percentage Yield, referring to the amount of money or interest you’ll earn over the course of a year in an account. The APY rate tells you the rate at which your invested money will grow– higher numbers equal higher savings rates.
Several financial products have APY rates, though you’ll most commonly find them across savings accounts, some checking accounts, certificates of deposit (CDs), and cash management accounts. Accounts that are less liquid (or more challenging to withdraw funds from) tend to have higher APYs.
APY products take compound interest into account, meaning that the rate is calculated based on the interest rate itself, as well as the money earned on top of that amount from holding a balance over time. Interest is compounded regularly, whether that’s daily, monthly, or yearly based on the parameters of the account.
Variable vs. Fixed APY
Keep in mind that APY can be variable or fixed, so your rate might be subject to change. With variable APYs, the rate can change based on your bank’s parameters, usually in response to larger changes in the economic environment. For instance, the Federal Reserve may be raising rates, leading your lender to do the same in response.
There are also reference rates called benchmark rates. These rates are populated by an independent party and are used to reflect borrowing costs across several markets. The perception of benchmark rates can also shift variable APYs.
On the contrary, you’ll come across fixed APYs that hold the same APY rate for the course of your agreement. For instance, if you have a 2% APY for a certificate of deposit for two years, it will stay at that 2% regardless of the outside economic conditions. In some cases, there may be “raise your rate” financial products like CDs that allow you to pitch for higher APY rates under certain conditions, but change isn’t guaranteed with a fixed rate.
One type of APY isn’t necessarily more effective than another– it largely depends on the external economic conditions and your personal financial situation.
How To Calculate APY
You’ll be presented with the APY rate for your desired savings account, but it’s always a good idea to have an understanding of how this rate is calculated. To calculate APY, we need to have a clear sense of the following variables:
r = Interest Rate
n = Amount of Compounding Periods
The goal is to calculate the rate of growth on a yearly basis, taking into account earnings from compound interest.
So, to calculate the APY, we use the formula:
APY = (1 + r/n)n – 1
This can be used to calculate interest, but you can also utilize spreadsheets to help get to your figure as soon as possible. Fortunately, most banks provide this information upfront so that you can quickly compare and contrast. Be sure to consider whether you’re opting or a fixed or variable APY rate discussed below.
APY vs. APR
APY and APR are similar, but different concepts. APR represents the amount of money charged for borrowing money that includes fees but not compounded interest. For instance, a credit card may have a variable or fixed APR rate, though the borrower will have to pay more if they do not pay off their balance from one statement to the next since APR doesn’t account for compound interest.
APY is related to earning interest, rather than paying interest. This is the amount of interest you’ll earn back on a savings account or other investment product, considering compounding interest over a set period of time.
APY vs. Interest Rate
Annual percentage yield and the interest rate work hand in hand, but they aren’t the same thing due to compounding interest. The interest rate simply describes how much a figure is expected to grow over time. APY takes into account the interest rate, plus the compounded gains accumulated over time.
The Magic Of Compound Interest
The power of compounding interest ensures that the faster your savings grow, the faster you’ll earn returns. For instance, let’s say you invest $100 and get a return of $110 over the course of a year. In year two, you might still have the same interest rate, but your APY could be higher since you aren’t just earning interest on the $100, you’re now building on top of the $110 foundation.
Compound interest lets you consistently build your income over time. The rate at which your accounts compound depends on your specific financial products, but compounding could happen on a daily, weekly, monthly, or annual basis. It’s in your best interest to have your accounts compound as much as possible to maximize your returns.
Which APY Account Is Right For Me?
One of the first factors to consider when selecting a financial account with an APY is what type of account you’re looking for. If you’re able to sock away your earnings for longer, you’re likely to receive higher gains from an investment-tailored account.
By contrast, if you need your savings more liquid, a traditional bank account or savings account may be your best bet:
Using APY For Investment Decisions
These accounts tend to have higher APYs than savings accounts, since they are less liquid.
- Certificate of Deposit (CDs): Certificates of deposit have a fixed APY rate in most cases with a set term agreement. There may be a minimum or maximum deposit for any particular CD, and money withdrawn before maturity will incur penalties.
- High-Yield Savings Account: High-yield savings accounts present slightly higher interest rates than traditional savings accounts, though they are more liquid than accounts like CDs. Like regular savings accounts, high-yield savings accounts often have variable APYs.
APY Across Different Bank Accounts
For a more liquid approach, you might want to consider one of the following types of financial accounts:
- Traditional Bank Accounts: Savings accounts at traditional banks are convenient, easy to set up, and typically fairly liquid. On average, savings accounts earn an APY of around 0.40%.
- Credit Unions: Credit unions provide APYs based on a dividend based on their member pool. These institutions may have specialized requirements for entry, though they can often offer higher APYs than traditional banks.
- Online Banks: Online banks have no physical locations, allowing them to pass along savings in earnings to increased APYs relative to traditional banks.
Credit Union Specifics: Dividend Rate vs. APY
Credit unions pay a certain amount of interest or dividends based on their member pool. This acts as an interest rate, which tends to be higher than a less-exclusive general savings account from a bank that’s open to anyone.
A credit union’s APY utilizes the dividend rate (or how much interest is being paid out to a member) and takes into account compounding interest for a set period of time. For instance, you might have a dividend rate of 3.5%, but due to your credit union’s rate of compounding interest, your APY might come out to be more around 3.8%.
Strategies for Maximizing APY
You’ve built out a sum for savings, and you’re understandably shopping for the best APY possible. Here are a couple of strategies to help you maximize your savings rate:
- Look out for introductory offers. Some banks offer introductory offers and bonuses for set deposit amounts or new customers that can help give your initial investment a free boost so long as you meet the conditions.
- Compare rates over a set period of time. It’s key to have a good idea of how long you’d like to tuck away your savings so that you can effectively evaluate variable vs. fixed APYs. If you need the money to be more liquid, fixed rates might be out of the question altogether.
- Take fees into account. Don’t forget to zoom out and look at the full picture of a prospective bank– if your savings account(s) come with fees that offset much of the APY benefits, it might be best to look elsewhere.
- Opt for an online bank. If you don’t require a bank account with a physical branch, look into an online savings account. These savings accounts tend to have higher APY rates since they don’t have to invest as much into onsite personnel and maintenance.
Whenever you evaluate an account, start by determining whether you’re working with a variable or fixed APY rate. Next, you can compare your APY rate against other accounts, to ensure you have the optimal choice for your financial needs. Finally, look into your account’s terms and conditions to make sure you understand the full scope of the agreement before committing to a savings account or certificate of deposit.
Understanding how APY works can help you become a savvy saver and, quite literally, get more bang for your buck.
Frequently Asked Questions (FAQs)
Which is more beneficial for savers, APR or APY?
APY is more beneficial for savers as it accounts for compound interest, showing the total interest you earn over a year.
What Constitutes A Competitive PAY For Savings Accounts?
A competitive APY typically exceeds the national average, which can vary. As of my last update in 2021, anything above 0.5% was considered competitive, but this rate can change with market conditions.
Which Financial Institutions Currently Provide The Highest Savings Account APYs?
It varies over time. Always research current rates from various banks, including online-only banks, as they often offer competitive rates.
How Do Apr And APY Differ In Their Calculations?
APR represents the annual interest rate without considering compound interest, while APY includes compound interest, providing a more accurate picture of total earnings over a year.
Why Does APY Fluctuate Across Banks?
APY can fluctuate due to factors like a bank’s operational costs, its need to attract deposits, general economic conditions, and monetary policy set by central banks.
How Does Compound Interest Affect APY?
Compound interest allows interest to be earned on both the principal amount and any previous interest earned. APY considers this compounding effect, so higher frequency compounding results in a higher APY.
Is A Higher APY Always Indicative Of A Better Savings Account?
Not necessarily. While a higher APY offers better interest earnings, other factors like fees, account features, and customer service should also be considered.