Common uses
Interest rates are a frequent feature in your everyday banking, ranging from savings products and investments to credit cards and loans. They may help you calculate how much you might earn on your savings in a year or approximate a monthly payment on a loan.
While interest rates may give you an idea of how much you’ll save with your savings account or CD, they might not tell the whole story. You may also want to learn about your account’s APY, which includes how the interest is compounded over the course of a year.
APY (annual percentage yield)
APY refers to the rate of interest that you earn on your funds in a year’s time. It includes interest that was earned on the original account balance, as well as the interest that is compounded over the course of one year.
APY and compounding
Depending on the type of account that you have, interest might compound annually, quarterly, monthly, weekly or daily. If you choose not to withdraw from an account, your financial institution will typically pay interest on your principal, plus any funds you’ve earned in interest previously. How often the interest is compounded will affect how much you earn over time.
For example, if you deposit $1,000 into a savings account that compounds 5% interest once a year and you don’t withdraw from it, your account balance will be around $1,050 at the end of the year. If your account compounds 5% interest on a daily basis over that same year, you would have around $1,051. This is because compound interest incorporates the new interest accumulated every time it compounds. While one dollar may not sound like a big difference, over time and with larger balances, the rate at which your account compounds can add up.
Typical use in savings accounts and investments
You’ll often see APY used for savings accounts and CDs because they show the total return on your deposit more clearly. Since you might see more of your earnings for the year with APY, it might be a preferred metric for financial institutions over interest rate.
Key differences
Some key differences between interest rate and APY include how they’re calculated, whether or not they are compounded and how much interest you earn after a year. Let’s take a closer look at these factors.
Calculation
Interest rates are generally based on an index and provided to you by your financial institution. If you make a deposit worth $10,000 to a CD with a 6% interest rate, after one year, your balance would be $10,000 + 6% of $10,000, for a total of around $10,600 before compounding.
APY is more comprehensive because it takes into account how frequently interest is compounded over a year. If you deposit $10,000 in a CD that earns 6% in interest and compounds on a monthly basis, the APY would be around 6.17%. That means that after a year, your balance will be around $10,617: $10,000 + 6.17% of $10,000.
Compounding
Interest rate alone doesn’t speak to the number of times that interest is compounded over a given period, which is the main factor that separates it from APY. How frequently your financial institution compounds the balance of one of your accounts affects how much you earn, because every time your interest is compounded, it adds to the total balance that you are calculating from.
Total returns
Since APY takes into account how frequently your interest gets compounded by your financial institution, a higher APY, even on the same interest rate, will reflect more money added to your account over a year’s time.
Let’s say you’re choosing between two CDs that both have interest rates of 5%. At first glance, it might seem like if you deposit $5,000 into either CD, your balance would be around $5,250 at the end of the year. But to get a better sense of total returns, take a look at each CD’s APY, which incorporates how often the interest compounds. If one has an APY of 5.1% and the other has an APY of 5.13%, you can expect a higher total return from the second CD.
APY vs. interest rate in savings accounts
APY and interest rates may both be useful metrics when you go to open a savings account. Let’s examine how each might be used to grow your savings.
Interest rates on savings accounts
Banks might quote both an interest rate and an APY for your savings account. While the interest rate is undoubtedly useful for understanding how much your account may earn, it doesn’t give a full picture because it doesn’t include compounding.
APY for savings accounts
Since APY incorporates the interest rate and how often your interest compounds, it will likely give you a better idea of your account balance at the end of a year.
How interest rates vs. APYs may affect savings account returns
Using APY to decide where you deposit your savings may help you to make a more informed decision. Accounts that offer higher APYs for your savings may yield more for you in the future, so shop around and compare. Accounts may have the same interest rates but different APYs, which affects how much you’ll eventually earn.
You can also ask a representative at your financial institution to clarify the interest rate on your account and how often it’s compounded. Asking more questions about how to grow your funds may be a useful way to learn more about your personal banking.
Disclosure: This article is for general educational purposes. It is not intended to provide financial advice. It also is not intended to completely describe any Citi product or service. You should refer to the terms and conditions financial institutions provide for various products.
