If you’ve been researching different savings products, you’ve probably seen the term APY.
If you’re confused, you’re not alone.
APY, or annual percentage yield, is the total interest you will earn on a savings account or certificate of deposit in one year, including all compounded interest. APY is a good number to use when comparing different savings accounts or CDs.
Think about it this way: If you were to zoom in to see part of a photograph, that portion would be the interest rate. But when you zoom out and see the whole thing, that’s the APY.
Interest rate is just a part of it. The interest rate doesn’t tell you anything about how often your interest is compounded — it doesn’t tell the full story.
Two savings accounts with identical interest rates can end up with different annual percentage yields if the interest on one account compounds more often than the other. Here’s an example: Let’s say you have two accounts, each with $10,000 and an interest rate of 2%. But one compounds annually while the other compounds daily. Here’s what the math looks like:
As you can see, the account with interest compounded daily will end up with more earned interest. Now, here’s a quick note about compounding interest. Compounding interest is essentially earning interest on your interest. Every time the interest compounds, that little bit gets added to your balance.
Then, when the interest compounds again, you earn even more interest because your balance has grown. That compounding effect (and how often it compounds) is what differentiates interest and APY.
And it’s also why Albert Einstein allegedly called compounding interest the eighth wonder of the world — because, with enough time, a little bit of principal in the beginning can become a mountain of cash.
So, next time you’re shopping for a savings account or CD, look for the APY. If you want to calculate how quickly your savings can grow (the fun part!), check out the savings calculator from Marcus by Goldman Sachs.
Just a quick side note: If you’re looking at savings accounts and CDs, forget about APR. APR, or annual percentage rate, is the yearly cost of borrowing money. But, just like you use APR to compare different loans, you can use APY to compare savings accounts or CDs.
See, that wasn’t so hard.