If you've been looking at interest-bearing accounts like high-yield savings accounts or certificates of deposit (CDs), you may see the terms "interest rate" and "annual percentage yield" (APY) being used interchangeably. While both are related, they mean entirely different things, and knowing the difference is essential in understanding the rate of return you'd get on your deposits.
CNBC Select breaks down the difference between these two terms and why it matters.
What's the difference between APY and interest rate?
APY is the total interest you earn on money in an account over one year, whereas interest rate is simply the percentage of interest you'd earn on a savings account, investment or loan. In other words, the interest rate of an account is just one component of the account's APY, which also factors in how often your interests compounds. That's why with deposit accounts (like a high-yield savings account), the account's APY will give you a more accurate measurement of how much money it will earn in a year.
Example of APY vs. interest rate
To have a better understanding of how interest rates and APY would impact your money, here's an example:
- If you were to deposit $1,000 in an account earning a simple interest of 5% paid after one year, you'd earn $50 in interest. That would total $1,050 at the end of the year.
- Now, let's say you've deposited $1,000 in a high-yield savings account with a 5.00% APY that compounds monthly.
- To figure out how much interest you'd earn each month, you'd divide 5% (expressed as a decimal as 0.05) by 12 (for the 12 months in a year). Then, multiply that number (approximately .00416) by 1,000 (your principal), and you'd get about 4.17. This means you earn $4.17 in interest on that initial $1,000 deposit after one month.
- For the following month, you're now earning interest on $1,004.17. So, instead of multiplying the monthly interest (.00416) by the initial principal, you'd multiply the interest by $1,004.17 (which is the initial principal + the interest earned from last month). With this, you'd get 4.18, meaning you'd earn about $4.18 in interest after the second month. That brings your total after two months to $1,008.35
- Over the year, this would add up to a total of $1,051.16.
Note that these numbers reflect an interest rate that compounds monthly, and it doesn't consider any additional contributions to the account.
Which one is important to know for savings accounts?
Financial institutions tend to advertise APY over interest rates with savings accounts to help you understand how much money you'd earn over time. The higher the APY is in a savings account, the faster your money will grow.
APYs for high-yield savings accounts, for example, can be 10 to 12 times higher than traditional savings accounts. CNBC Select ranked Western Alliance Bank High-Yield Savings Account as the best high-yield savings account with a whopping 4.30% APY as of writing for anyone looking to maximize their returns.
However, while interest rates on high-yield savings accounts are variable and can fluctuate in accordance with the Federal Reserve changing its benchmark, you can also lock in a high-interest rate with a CD. Ally Bank® CDs come with a variety of term lengths that can earn APYs as high as 4.00%.
Western Alliance Bank High-Yield Savings Account
Annual Percentage Yield (APY)
4.25% APY
Minimum balance
$1 minimum deposit
Monthly fee
None
Maximum transactions
Up to 6 transactions each month
Excessive transactions fee
The bank may charge fees for non-sufficient funds
Overdraft fee
No overdraft fee
Offer checking account?
No
Offer ATM card?
No
Terms apply.
Ally Bank® CDs
Annual Percentage Yield (APY)
From 2.90% to 4.00% APY
Terms
From 3 months to 5 years
Minimum balance
None
Monthly fee
None
Early withdrawal penalty fee
High Yield CDs and Raise Your Rate CDs have early withdrawal penalties that vary based on your CD term. With the No Penalty CD, withdraw all your money any time after the first 6 days following the date you funded the account and keep the interest earned with no penalty.
Terms apply.
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Bottom line
Understanding the difference between APY and interest rates can take time and effort. Still, the key thing to note is that interest is the percentage you earn on a balance, while APY measures the interest you'd make over a period of time — typically a year — with compound interest included. With savings accounts, banks advertise the APY to give you a clear picture of how much your money will earn.
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