December 17, 2019
Tagged As: Personal
Have you ever seen an advertisement or promotion that mentions APY, and you really don’t understand what that means?
If you’re considering taking out a certificate of deposit (CD), interested in high-interest checking, or just curious, it’s worth taking a deeper look into the relationship between annual percentage yield (APY) and the interest rate on any given deposit account. To do so, we’ll give you the basics and then use some math to help explain why the distinction between APY and interest rate can end up making a big difference for your finances.
Interest and interest rates
Simply put, interest is money charged on the balance of a loan or paid for keeping money on deposit. Most of us have personal experience with paying interest, whether on a loan, a credit card, or other kinds of debt. This kind of interest is often disclosed as annual percentage rate, or APR.
But you can also earn interest on the balance of a deposit account or product, such as an interest-bearing checking account, savings account, or a CD, since you’re essentially loaning your money to a financial institution. For the remainder of this article, we’ll assume you’re earning interest in this way, rather than paying it as part of a loan.
Interest is written as a percentage, which refers to the amount that is earned on the balance of a deposit account during a given cycle. Many accounts earn interest once per year, while others have more frequent interest cycles.
In most cases, interest isn’t just earned on the starting balance of an account (a.k.a. simple interest). When it comes time for interest to be calculated, it accumulates on top of previous interest earned – a process called compounding.
Compound interest and annual percentage yield (APY)
To illustrate how compound interest is preferable to simple interest, we’ve created a graph of a common way it’s applied: investments.
Though the compounded value shown above grows slowly at first, over time the growth you can see from a modest investment compounded annually far outweighs the actual amount of money put into the account. Compounding transforms your working money into a state-of-the-art, highly powered income-generating tool. When your investments generate earnings, those earnings are added to your account and reinvested. Now you have a larger pool of invested money – your contributions plus your earnings – and the opportunity to generate even more earnings on those invested funds. Compound interest is one of the reasons why financial advisors recommend saving for retirement early: because you’ll have more time to let your money make money.
While the example above is a great way to show an investment with a high interest rate that continues compounding over a long time, most financial products that advertise an APY offer more modest returns. But whether you’re talking about investments, savings accounts, or high interest checking accounts, the principle of compound interest remains the same. It’s why APY is different than the interest rate: because you’re not just receiving interest on the amount in your account, but interest on the interest you’ve already received!
Now that you’re an APY expert, why not take a look at our interest and APY rates for deposit accounts?