If you’ve been looking to build your savings, you’ve probably come across interest-bearing accounts like high-yield savings accounts or certificates of deposits (CDs). The terms “interest rate” and “annual percentage yield” (commonly referred to as APY) tend to be thrown around a lot, and seem to be used interchangeably. While they are definitely both related, they actually mean entirely different things. Knowing the difference will help you understand the rate of return you’ll get on your deposits.
Below we break down the difference between these two terms and explain why it matters to know the difference.
Types of interest.
Let’s start with interest rate. There are two types of interest: simple and compound.
The difference between simple vs. compound interest when it comes to a savings account will determine the speed at which your money could grow.
Simple interest is quite…simple—you just multiply your balance by the interest rate.
Now, with compound interest, your money can grow at a faster pace. This is because with compounding interest, you earn interest over set periods of time and the interest you earn is added to the balance.
An important aspect of compound interest is knowing how often your interest will compound. APY takes into account not only interest, but also the rate at which it compounds.
So what does that mean exactly? Well, over each new compounding period you earn interest on the interest you’ve already gained. The more often your money compounds, the more you can earn.
Typical compound periods include daily, monthly, quarterly, or annually. This is why it’s so important to know how often the interest compounds on your account.
Example of the difference between simple and compound interest rate.
Let’s say you have $10,000 and your account has an interest rate of 5% paid after one year, without compounding. The amount of interest you earn is $500 ($10,000 x 5% = $500).
For compounding interest, let’s pretend that instead of waiting one year, the bank deposits the interest earned after each month. Using the example above with a 5% interest rate on a $10k deposit, your interest would be $500, and broken down over 12 months, that’s $41.67. So the balance at the end of the first month would be $10,041.67.
The exciting part is that you now earn 5% interest on $10,041.67. Each month, your interest compounds on your growing balance
The next month, you will be earning interest on the new, larger balance. Watch this cycle repeat and your savings grow!
What is APY?
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. APY also factors in the frequency of compounding. APR stands for “annual percentage rate,” and that’s the amount of interest you would expect to pay if you were taking out a personal loan to borrow money. In short, APY is what you gain, and APR is what you will pay.
The difference between APY and interest rate.
Let’s get right down to it.
APY is the total interest you earn on money in an account over one year, whereas interest rate is simply the percentage of interest you’d earn on a savings account, without compounding. Simply put, the interest rate of an account is just one component of the account’s APY, which also factors in how often your interests compounds. That’s why with deposit accounts (like a high-yield savings account), the account’s APY will give you a more accurate measurement of how much money it will earn in a year. Since APY is important, many financial institutions will display that number on their websites or advertisements, and that number is what catches your eye.
Which one is more important for savings accounts?
Most financial institutions advertise APY instead of interest rates so that you understand how much money you can earn over time. The higher the APY, the more your money will grow.*
For example, the APY for high-yield savings accounts can be 10 – 12x higher than traditional savings accounts.
While interest rates on high-yield savings accounts are variable (meaning they can fluctuate), you can lock in a high-interest rate when you open a CD.
Start saving today.
Whether you need easy access to your savings or want to lock in a great rate, we have options to help you reach your savings goals. Valley Direct is an online only option with multiple ways to grow your money. No need to head into a branch or get on the phone—apply online and get started within minutes.
*Depending on compounding frequency, money might not actually grow “faster”.
This article is for informational purposes only and is not a substitute for individualized professional advice. Individuals should consult their own tax advisor for matters specific to their own taxes and nothing communicated to you herein should be considered tax advice. Valley National Bank does not provide any financial, economic, legal, accounting, tax or other recommendation in this article. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice. Information contained in this article does not constitute the provision of investment advice by Valley National Bank or any its affiliates. Neither Valley National Bank nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of the statements or any information contained in this document and any liability therefore is expressly disclaimed.
