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.
How to Calculate APY
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 the compound interest.
|Initial Investment||APY||Standard APR|
- APY Formula: 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 amount to open the account and may need a minimum balance requirement to avoid monthly fees. These accounts may not earn very high interest due to their flexibility and low required balances. However, most of these investment 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 Platinum Savings account earns 5.05% APY on balances $5,000 and more or 0.25% APY on balances under $5,000. Synchrony Bank high yield savings account requires no minimum balance to earn 4.75% APY. Granted, you will only earn a few pennies if you only have $100 in your account, but both of these savings accounts charge no account opening or maintenance fees.
Money Market Accounts
Money market accounts (MMA) are a type of account that earns interest based on the current rates in the money markets. With a performance savings account from Capital One, there is no minimum balance to meet to to earn the Annual Percentage Yield of 4.30%. Note that APY and interest rates are variable and may change at any time. Compared to other accounts, MMAs are not high-yield interest vehicles, but allow account holders to have higher access to their funds.
A certificate of deposit (CD) is a timed deposit account. Banks require money to be left in a CD for a period of time to earn interest. This makes CD accounts a less liquid asset. CD rates are typically higher compared to other types of account. Thus, 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 amount 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 offer 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.
Frequently Asked Questions
What is a good APY rate?
A good APY (Annual Percentage Yield) rate can vary depending on the financial institution and the type of account. Generally, a good APY rate is one that is higher than the average APY rate offered by other banks or credit unions. It is also important to consider factors such as the level of risk associated with the investment, the duration of the investment, and any potential fees or limitations. Ultimately, a good APY rate is one that offers a competitive return on investment while still meeting your individual financial goals and needs.
Why does APY matter?
APY is important because it helps individuals and businesses understand the actual return on their investments or savings over time. It takes into account compounding interest and allows people to compare rates to make informed decisions. Financial institutions also use APY to attract and retain customers by offering competitive rates.
How can APY assist an investor?
APY helps investors compare interest rates and returns on different investment accounts. It allows them to assess the impact of compounding and make informed decisions about their investment strategy. Overall, APY maximizes investment opportunities for investors.
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