Say “interest rate,” and the next words that come to mind are, inevitably, “loans” or “credit cards.” Fortunately, “interest rate” doesn’t always have to refer to “owing more money on principal.”
Change the terms slightly and you get “interest earnings.” Voila! That equates to a much happier (and more profitable) train of thought.
Interest earnings have two correlated terms: APR and APY. The common acronym is APR, which refers to annual percentage rate. A little lesser-known term is APY, or annual percentage yield. They both calculate interest earnings, but one calculates annually and the other may calculate daily or monthly, depending on the financial institution.
APY vs. APR
APR computes interest for investments. This means that if you have $10,000 in an interest-earning account for the entire year, and your APR is 1.25%, you will have earned interest of $125 for the year. At the end of the year, you will have $10,125 in your account after interest is applied.
APY is a slightly more complicated calculation to compute earned interest, but it’s more profitable for the account holder. APY is more profitable because of compounding interest.
|Initial Investment||APY||Standard APR|
- Equation: A=P (1+r/n)^nt
- Variables: A = earned investment amount, P = initial investment amount, r = annual interest rate, n = number of times interest is compounded throughout a one year period, t = number of years for the investment
- Daily calculation: $101,257.82 = $100,000.00 ( 1 + (0.0125/365)) ^(365*1)
- Monthly calculation: $101,257.19 = $100,000.00 ( 1 + (0.0125/12)) ^(12*1)
- Quarterly calculation: $101,255.87 = $100,000.00 ( 1 + (0.0125/4)) ^(4*1)
- Yearly calculation or APR: $101,250.00 = $100,000.00 ( 1 + (0.0125/1)) ^(1*1)
In order to see what your account balance will yield, take your initial investment, multiply it by 1, plus the interest rate divided by the number of compounding periods. Take the total and apply it to the power of the number of compounding periods multiplied by the investment years.
As shown in the chart above, the more frequently the interest is compounded, the higher your yield.
Types of APY accounts
Savings accounts earn interest based on the account balance. Some banks require a minimum deposit to open the account and they may also require a minimum balance to avoid monthly fees. These accounts may not earn very high interest due to their flexibility and low required balances. However, most of these accounts can be opened for free.
Some banks will even provide a bonus for opening an account and setting up direct deposit. Other accounts may require a minimum balance to earn interest. CITBank requires a minimum balance of $100 to earn 1.55% APY. Synchrony Bank only requires a minimum balance of $1 to earn 1.55% APY. Granted, you will only earn a few pennies if you only have $100 in your account, but both of these savings accounts charge $0 in fees. If either account was opened with $10,000 and no other deposits were made for one year, the account would yield $156.20 in earned interest income.
Money market accounts (MMA) such as CapitalOne require an initial balance of $10,000 and a minimum balance of $10,000 to earn the 1.5% APY. If only that one deposit of $10,000 is made, the account would yield $151.13 in earned interest income. Compared to other accounts, MMAs are not a high-yield interest vehicles, but allow account holders to have higher access to their funds.
A certificate of deposit (CD) is a timed deposit. Banks require money to be left in a CD for a period of time to earn interest. This makes CDs a less liquid asset. However, for the potential gain, it can be worth it.
For a five-year CD with 2.65% APY, the value of a $10,000 deposit at the maturity date would be $11,416.73. If the same $10,000 was deposited into the savings accounts above, it would only have earned $805.80 in interest. However, savings accounts are more liquid and you can access your funds at any time. CDs lose value if cashed in early, not just in penalties and loss of interest, but the initial principal could be affected as well. If you open a CD, be sure you do not plan on needing these funds for the duration of the deposit.
Why do banks offer loans at 5.5% for a $25,000 car loan, but only offer .03% APY on savings accounts?
The simple answer? To make money.
If banks offers higher rates for interest-earning accounts than for loans, people could borrow money from the bank, turn around and open an interest-earning account. As the account earns interest, the bank would lose money on the transactions as a whole. The bank assumes risk by loaning out funds. For that risk, they charge the loan interest as a gain to secure their repayment.
APR may be easier to calculate, but understanding extra calculations for APY and compound interest is worth the extra brain workout. It’s important to learn how your accounts are earning money for you as well as earning enough interest for your needs.