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And while APY and interest are related, they’re not interchangeable. When it comes down to it, what you want to look for is APY.
First, let’s talk about interest. When you deposit money into an account with a bank, the bank doesn’t just hold onto the money for you; it can lend it out to others. In return, the bank pays you money; this is interest.
The interest rates on savings accounts and CDs can change and are partly affected by what the Federal Reserve is doing. Generally when the Fed raises the federal funds rate, interest rates on savings accounts increase. The opposite may also happen to interest rates when the fed funds rate decreases.
Rates on CDs may also change. But when you open a CD, the rate for that CD is typically fixed for the entire term.
The difference between simple vs. compound interest for a savings account will determine how fast your money could grow. Simple interest really is quite simple; you just multiply your balance by the interest rate.
For example, let’s say you have $10,000 (that you don’t touch) and a bank offers an interest rate of 2%. You’ll multiply $10,000 by 2% which equals $200 at the end of the year. So your interest will be $200 - not bad.
Now for compound interest - compound interest for a savings account can grow your money at a faster pace. This is because you earn interest on your interest.
An important part of compound interest is understanding how frequently your interest will compound. Take our example from above where you earned $200, making your new balance $10,200. Let’s say your interest will compound annually, so after your first year, your balance is $10,200.
In your second year you’re applying 2% to $10,200 meaning you will earn $204 instead of $200. Leave your money in this account for 10 years and you’ll reach $12 ,189.94 vs. $12,000 if it were simple interest, an extra $189.94 is the compounding effect!
So now you understand interest. Let’s throw another term at you.
APY stands for “annual percentage yield,” which is the amount of interest, shown as a percentage, you will earn if you keep your money in a savings account or CD for a year. The reverse of this is APR “annual percentage rate," the amount of interest you would expect to pay if you were taking out a personal loan to borrow money. Learn more about APY vs. APR.
APY takes into account not only interest but also the rate at which it compounds. With compounding interest, you earn interest over set intervals of time and the interest you earn is added to the balance.
In effect, over each new compounding period you earn interest on the interest you’ve already earned. The more often your money compounds, the more you can earn. Sound familiar? Because our example above had the interest compounding annually, you can think of that 2% as the saving account’s APY.
And with that example, you also now know how to calculate APY, but we’ll spell it out further below. Learn more about how to calculate interest for a savings account.
Interest typically compounds daily, monthly, quarterly or annually. This is an important point, so if you don’t know how often the interest compounds on your account, be sure to check your account details.
Still with us? Good. Because here’s where things get really interesting.
If you’re shopping for a savings account or CD, you might look only at the interest rate. The higher the rate the better, right? But there’s actually more to it. Interest rates alone don’t give you the entire picture. You also need to look at how frequently the interest compounds, because the frequency helps determine how much money you could earn.
Here’s what we mean:
2% Interest Compounding Daily
2% Interest Compounding Daily
Return (Including Initial Investment)
In this instance, everything seems almost identical — the term, interest rate and initial deposit are exactly the same. But the outcome is different: You earn about $10 less if you go with the account that compounds interest annually. Because of this, since it takes compounding interest into account, what you should really be looking at is the APY.
Because APY is important, many banks take that number and display it in big print on their websites or advertisements. If you can’t find it, check the fine print.
And if you’re looking for a high-yield savings account or CD, Marcus by Goldman Sachs® has you covered. Our competitive interest rates compound daily. Calculate how your money could grow with our Savings Account Calculator and our CD Calculator.
This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this site were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA or any of their affiliates, subsidiaries or divisions.