An interest rate is either the amount you pay to borrow money from a lender, or the amount paid to you on a savings account. It is expressed as annual percentage rate or APR representing the percentage of interest you might pay on money you borrow in the form of a loan or credit card. In the context of savings accounts, interest rate may also be referred to as APR.
The annual percentage yield or APY to represent the percentage rate reflecting the total amount of interest paid on a savings or CD account for the period.
Calculating interest rates for savings accounts
Here’s an example of how to calculate APY:
Let’s say you deposit your emergency fund of $2,000 into a savings account that offers a 2% APY. After one year, assuming no withdrawals or deposits and that the interest rate doesn’t change, you will earn $40 in interest.
Simple interest vs. compound interest
An interest rate may be simple or compound.
For a savings account, simple interest is calculated on an account balance. Compound interest means each time the interest amount is calculated and added to the account balance, the cumulative balance earns interest. With compounding interest, you earn or pay interest on both the original amount, or account balance for savings accounts, on the interest the bank pays or charges you each period to keep money in the account.
Interest may be compounded daily, weekly, monthly, semi-annually or annually. For a given annual percentage yield on a savings account, the more compounding periods within a year, the higher the APY.
Here’s an example of how daily compounding interest works:
| Opening Balance | Interest Rate: 3%* | Closing Balance | |
|---|---|---|---|
| Year 1 | $5,000 | $152 | $5,152 |
| Year 2 | $5,152 | $157 | $5,309 |
| Year 3 | $5,309 | $162 | $5,471 |
| Year 4 | $5,471 | $166 | $5,637 |
| Year 5 | $5,637 | $171 | $5,809 |
| Year 6 | $5.809 | $177 | $5,986 |
*3% interest compounded daily - interest is calculated on the principal amount plus the interest earned for 365 days.
APR vs. APY
We will transition from numbers to letters when it comes to different types of interest rates. These terms are important when it comes time to open a savings account or take out a loan, so we'll walk you through the differences:
- Annual Percentage Yield (APY): This rate explains how much your money can make in a given year when you deposit funds in a savings account, Certificate of Deposit (CD) or other interest-bearing account. APY is based on the interest rate, but also accounts for compound interest to give you a clearer picture of what you might earn.
- Annual Percentage Rate (APR): This varies slightly from the actual interest rate when you borrow money because it includes the interest rate plus fees. · This rate is typically used for loans or credit. When APR is used for savings products, APY is the same as the interest rate which is the annual rate of interest paid on account which does not reflect compounding.
This article is for educational purposes. It is not intended to provide legal, investment, or financial advice and is not a substitute for professional advice. It does not indicate the availability of any Citi product or service. For advice about your specific circumstances, you should consult a qualified professional.
