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Updated on Wednesday, October 31, 2018
When you’re signing up for a checking or savings account, the first thing you are likely to review is the account’s APY and interest rate. They may seem similar but they are actually two very different terms.
An interest rate is the percentage of your deposit that banks pay you in order to hold your money with them. APY is an acronym that stands for for annual percentage yield. It refers to the total amount of interest you earn on your savings over a year, and it factors in compounding interest. APY gives a truer picture of how much money you will make from your certificate of deposit (CD), savings or money market account, than by looking at a simple interest rate alone.
The higher the APY, the more money you can expect to earn from your deposit in your CD, money market or savings accounts.
Understanding the various types of interest rates
For deposit accounts, there are two types of interest rates you need to know: simple interest and compounding interest.
Simple interest is easy to calculate — it’s calculated only on the principle you deposit in your bank account. It means if you invest $10,000 at an interest of 2%, for instance, you will earn $200 in interest at the end of the year.
Simple interest rates are typically used with brokered CD accounts purchased through brokerage firms like Fidelity, Vanguard or Charles Schwab, said Ken Tumin, founder and editor of DepositAccounts.com, a fellow LendingTree-owned site. Instead of receiving compounding interest, holders of brokered CDs normally get paid simple interest monthly, quarterly, semi-annually or annually.
Compounding interest is more complicated, because it takes into account the interest you earn on both the interest and principle. When you leave the interest you earn in a bank account instead of taking it out, the overall interest paid is calculated based on the total balance, including the interest you’ve earned over time. So as each month passes, you are earning interest on an increasingly larger pool of money.
That’s why compounding interest can be such a powerful tool and why you’ll hear many experts encourage folks to save as early and often as they can so that they have more time to enjoy the power of compounding.
Here is how compounding interest works. Let’s say you put $10,000 in savings account that earns an interest rate of 2%. After one year, you will have earned $200. So you’ll start year two with a total balance of $10,200. Now, you’ll earn the same 2% but you’ll be earning it on a higher balance (your original deposit plus $200 in earned interest). At the end of year two, the total interest on your deposit will be $204 — ($10,000+$200) x 2% = $204 — and you’ll be left with a total of $10,404.
Annual Percentage Yield (APY) vs interest
Most deposit accounts where you earn the interest use APY. It is a number that accurately represents how much you will make from a deposit in a given year, factoring in both the interest rate and compounding period.
If interest is paid on an investment once per year, which means it has an annual compounding period, as shown in the above-mentioned example, the APY and interest rate are the same.
But in reality, most banks offer more frequent compounding periods, which could be quarterly, monthly, weekly or even daily. In these situations, the compounding effect occurs on a much smaller scale but more frequently. As a result, the returns are higher.
Most banks offer an APY, so that account holders don’t have to calculate on their own. But if you are curious to know how an APY is calculated, the Federal Deposit Insurance Corporation (FDIC) provides the mathematical formula on its website.
Read more about the difference between APR and interest rate when it comes to mortgages here.
How to calculate APY
You can use DepositAccount.com’s compound interest calculator to calculate how much return you will eventually get on your investments over certain time periods. But if you’re someone who likes to see how the math works out, we’ll cover the formula as well.
APY = 100*[(1 + (interest rate/compounding cycles)^compounding cycles)) – 1]
Compounding cycles is the number of times a year your interest compounds.
Now if the 2% interest on that investment of $10,000 compounds daily (365 times of a year), at the end of the year, you will earn $202.01 in interest on that deposit. In this case, the APY is 2.0201%.
Here is how we arrived at the result:
APY = 100 * [(1 + (.02/365) ^ 365) – 1]
APY = 2.0201%
The deposit compounds monthly, meaning it has 12 compound cycles:
APY = 100 * [(1 + (.02/12) ^ 12) – 1] = 2.0184%
Blended APY comes into play when there are rate tiers in accounts. That means depending on how much you’ve invested, a portion of your balance earns one interest rate, while another portion earns a different interest rate. A blended APY averages the different interest rates and also factors in compounding.
Some financial institutions reward low balance savers by placing the highest rate with the lowest deposit, but if the balance grows they start using a reverse tier system where they blend the APY as the balance grows, Tumin explained.
These tiered rates are typically applied in money markets, savings and reward checking accounts, Tumin said. There can be more than two rate tiers, which it can make it more complicated to determine the final amount of interest you’ll earn over time.
Banks and credit unions that offer products that apply blended APYs usually list the rate tiers for different ranges of deposits. In this example, the blended APY is neither 1% nor 2%. The exact blended APY is calculated based on how much you have invested.
The formula that you can use to calculate the blended APY is:
Blended APY = (Amount1 * Rate1 + Amount2 * Rate2) / Total Amount
For example, let’s say you open a savings account that gives you 2% APY on your investments below $10,000 and 1% APY on deposits above $10,000.
You have $20,000 to deposit.
So, what we get from the $20,000 is:
Blended APY = ($10,000 * 2% + $10,000 * 1%) / $20,000 = an effective APY of 1.5%
Blended APY vs fixed APY:
Would you be better off picking an account with the blended APY or another account with a fixed APY of 1.5% on your entire balance?
It depends on your total balance.
Let’s say you put $15,000 in that same two-tiered account (2% on your first $10,000; 1% on deposits above $10,000).
Using the same formula from above, your blended APY would be 1.67%, beating a 1.5% APY.
But if you dump $50,000 into this account, your blended APY then would be 1.2%.
In this case, a fixed 1.5% APY would be a better deal for you.
When looking for savings accounts, you should shop around and compare the expected returns based on your initial investment.
Understanding the difference between APY, interest rate and APR
In the family of interest rates, APY has a sister called APR, which stands for annual percentage rate.
APR is often used to describe the interest rate you pay on loans and credit card debt. However, once in a while, you’ll see APR mentioned for deposit accounts, which essentially means a simple interest rate in that context, Tumin said.
When you are shopping for a loan, instead of looking at the interest rate, you should focus on APR, which provides a clearer picture of how much the loan will cost you.
An interest rate is the percentage of a loan amount that it costs to borrow money.
Essentially, APR reflects the amount of interest you pay on the money you borrow from a lender every year, and it also factors in how the interest is applied to your balance and associated fees and other costs. But unlike APY, APR does not take compounding into account.
If a lender charges no additional fees, the loan’s APR and interest rate are identical. But if you have to pay an origination fee for a loan, for example, it will increase the APR on that loan, making it higher than a simple interest rate.
Although lenders often advertise the interest rates, the Federal Truth in Lending Act requires that every lender to disclose the APR, so you can use the APR as a good basis to compare the true costs of loans. However, your monthly payment is calculated based on the interest rate, not APR. Here’s an example that shows how monthly payments are calculated using a loan calculator from LendingTree, the parent company of MagnifyMoney. The fees and other costs, such as discount points and origination fees are often paid at the closing of a loan or will be calculated into your loan balance.
This article contains links to DepositAccounts.com. Like MagnifyMoney, DepositAccounts.com is a subsidiary of LendingTree.