What is APY? How annual percentage yield impacts your savings

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When opening a savings account, you'll likely come across the term APY, which stands for annual percentage yield. But what exactly does APY mean, how does it work, and why does it matter when choosing a savings account?

We’ll break down everything you need to know about APY.

What is APY, and how does it work?

APY stands for annual percentage yield. It represents the total interest your account earns in one year, including the effects of compound interest. Essentially, it shows how fast your money can grow each year in the account.

A higher APY means your money has the potential to grow faster. When comparing savings accounts, you generally want to find the highest APY possible to maximize the growth of your money.

To understand APY, you first need to understand how compound interest works. Compound interest is what makes your money grow exponentially over time.

With compound interest, you earn interest not only on your initial principal deposit into the account. You also earn interest on the interest itself. This "interest on interest" concept makes compound interest so powerful for growing wealth.

Here’s an example to illustrate how compounding interest works. Let’s say you deposit $1,000 into a savings account with a 2% APY.

• After the first year, you would earn $20 in interest on your $1,000, bringing your total account balance to $1,020.
• In the second year, you’d earn 2% not just on your original $1,000 but on the $1,020 total account value. Since 2% of $1,020 is $20.40, your account balance at the end of year 2 is $1,040.40.

Over time, the interest added to your principal keeps compounding to accelerate the account growth.

APY vs. APR: What’s the difference?

You may have also seen the term APR, which stands for annual percentage rate. It's important to differentiate between APY and APR. as these terms are often confused.

While APY represents the interest earned on deposit accounts, APR describes the interest rate charged on loans or credit cards. They also account for interest differently: APY factors in compounding interest, while APR does not.

How to calculate APY

Wondering how much interest you could earn each year in an account? You can use the APY formula to find out.

Here is the basic formula for calculating APY in an account:

APY = (1 + (r/n))^n - 1

In this formula, the "r" represents the interest rate, and the "n" is the number of compounding periods.

Let’s plug real numbers into this formula to show you how the math works. Let’s say you:

• Deposit $10,000 into a savings account
• The interest rate is 2%
• The bank compounds interest daily (365 times per year)

Plugging this into the formula:

APY = (1 + 0.02/365)^365 – 1

APY = 1.020205 – 1

APY = 0.02 or 2%

If you deposit $10,000 with a 2% interest rate, you will earn $200 in interest after one year, making your year-end balance $10,200.

This illustrates why higher compounding frequencies provide better growth. The more frequently interest is reinvested into the account, the more you stand to earn over time, thanks to compound interest.

Why are high APYs important?

Clearly, the higher the APY on your savings account, the better it is for your annual return. But why exactly does a high APY matter so much for savings accounts?

It comes down to one word: inflation.

Inflation represents the rising costs of goods and services. Unfortunately, even low inflation gradually eats away at your savings over time. The less spending power your money holds in the future, the less wealth you’ll retain.

The average inflation rate fluctuates over time. Between 1960 and 2021, the average inflation rate was around 3.7% annually. In 2022, the average rate was 8%; in 2023, it was 3.4%.

Inflation decreases your purchasing power, so any cash sitting around would gradually lose value. That’s why APY is a crucial tool to outpace inflation to maintain and grow your savings.

The average savings account interest rate is around 0.47%, but you can often find much higher rates.

The higher your APY, the more your interest income can offset the effects of inflation. Ideally, your savings account APY will meet or beat the average inflation rate.

Comparing APYs when choosing a savings account

While a higher APY generally means better compound growth, not all rates are created equal. Some savings accounts may advertise high yields but have requirements that make those rates hard to obtain or sustain over time.

Here are some key factors that can affect APY:

• Account type: Online banks offer the highest savings APYs compared to brick-and-mortar branches. But make sure to read the fine print.
• Minimum balance: Many high-yield accounts require you to maintain a minimum deposit balance to earn the advertised APY.
• Qualifying transactions: Some accounts mandate a certain number of transactions or activities per month.
• Interest tiers: The APY may vary across different balance tiers in your account.
• Introductory rates: An account could offer a very attractive APY for the first few months, after which it decreases.
• Compounding frequency: More frequent compounding means higher potential growth.

Whenever you consider a savings account's published APY, review the details to understand what’s required to achieve those returns.

Where to find higher APYs

Wondering where to find savings accounts offering the best APYs? Here are a few places savers may want to consider:

• Money market accounts: These deposit accounts function similarly to savings products, along with debit card and check-writing abilities. Money market account rates can sometimes exceed essential savings yields.
• High-yield savings accounts: Many online banks offer high-yield savings accounts with competitive APYs. These accounts typically have fewer fees and higher interest rates than traditional brick-and-mortar banks.
• Certificates of deposit (CDs): CDs are deposit accounts that lock in your money for a specific period, such as six months, one year, or more. CDs typically offer higher APYs than savings accounts, but you won't be able to access your funds until the CD matures.

The bottom line

The APY ultimately shows how fast your money can grow in your savings account. Thanks to the power of daily compounding interest, accounts with higher APYs provide better returns.

Aim to choose the savings account with the best APY you can find. This will maximize your interest while maintaining your purchasing power over time. Monitoring the APY and current inflation trends helps ensure your savings dollars retain wealth now and into the future.

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