APY vs. interest rate: Learn the difference

When you open a savings account, how much money will you really earn? The answer lies in the annual percentage yield, or APY. Don't confuse your account's APY with its interest rate, though. While both reflect how much your money can earn, APY goes a little further than simple interest and includes compound interest.

Don't know what that means yet? That's OK. Learn more about APY vs. interest rate, why it matters and what to look for when opening an account.

What is an interest rate?

An interest rate is how much a deposit can earn. If you put $1,000 into a savings account that earns 4% interest per year, after one year, you'll have $1,040 in the account (assuming you didn't add more money or withdraw money from the account).

An interest rate can also refer to the amount you have to pay back in addition the amount of money you borrow. Banks and lenders charge borrowers an interest rate on credit cards and loans.

What is an APY?

When you open a savings account, certificate of deposit (CD) or money market account, you typically see the interest rate advertised as an APY. Usually, the APY is higher than the actual interest rate, but only slightly. A few checking accounts also offer an APY.

The APY is a more accurate reflection of how much you'll earn over a year. It uses compounding interest to help your money grow. Instead of paying you a lump sum of interest at the year's end, banks that use APY often pay interest monthly. So one month after depositing $1,000 into your account, you'd have $1,003.33. The next month, the bank calculates your interest rate based on the $1,003.33, not the original $1,000. So you earn slightly more.

The formula used to calculate APY is:

• (1 + r/n)ⁿ – 1
• r = Interest rate (converted to a decimal point)
• n = Number of compounding periods

For example, an account that compounds monthly and has an interest rate of 4% has an APY of 4.07%. Don't worry if you aren't good at math or don't own a calculator with the necessary functionality. Several online calculators are available that allow you to plugin your numbers and provide an answer for you.

What's the difference between interest rate, APY and APR?

The main difference between an APY and an interest rate is that APY takes into account compound interest. Since it allows for compounding, APY is higher than the simple interest rate.

Another term you may see used when referring to interest rates is annual percentage rate, or APR. While APY is used to explain how much money your savings can earn in a year, APR is used when you borrow money to explain the cost of taking out a loan or using your credit card.

How to compare APYs

When it comes to APYs, the higher the number, usually the better. But not always. Let's say you have $10,000 that you want to save. You come across a 12-month certificate of deposit offering an APY of 4.5% and a money market account offering 5.25%.

With the 4.5% CD, the APY is fixed for the duration of the CD. However, with the money market account, the APY can change based on the market. That can mean that a few months after you open the savings account, the APY drops to 3.5% or goes up to 5.5%.

It's up to you to decide if you want the slightly lower, but more stable CD or if you want to pursue the higher, but not fixed, APY. Another option would be to divide your savings, putting half into the CD and half into the money market account.

Explore your savings account options

Now that you know the difference between APY and interest rates, start exploring your savings options. Choose the savings account that's right for you.