When understanding the returns on your savings, investments, or loans, two crucial concepts come into play: the Annual Percentage Yield (APY) and the nominal Interest Rate. These terms often appear side by side, and while they both describe how money grows or accumulates, they do so differently. APY and the interest rate are fundamental in finance, and they are essential to grasp whether you’re considering a savings account, a certificate of deposit, or a loan. Let’s explore how APY vs interest rate can impact your financial decisions. With Beem high-yield savings account, you can get up to 5.00% APY. Put your money to work and watch it grow.
What’s the difference between APY vs interest rate?
| Aspect | Annual Percentage Yield (APY) | Interest Rate |
| Definition | The APY is a measure of the total return on an investment or savings account over a year, taking into account compound interest. It reflects the actual earnings you can expect. | The interest rate, often referred to as the nominal rate or annual interest rate, represents the percentage of the principal amount (initial deposit or loan balance) that is paid as interest or earned on an annual basis. It does not account for compounding. |
| Includes Compounding | Yes, APY considers the compounding of interest, which means it takes into account the interest that is earned on both the initial amount and any previously earned interest. | No, the interest rate is a simple percentage of the principal and does not consider any interest earned on previously accrued interest. |
| How It’s Advertised | Financial institutions typically advertise savings accounts, certificates of deposit, and other interest-bearing accounts using the APY because it provides a more accurate representation of the potential earnings. | Lenders and financial institutions often advertise loans or credit products using the interest rate, as it simplifies the calculation for borrowers. |
| Higher Value | APY is usually higher than the interest rate, especially when interest is compounded regularly (e.g., daily or monthly). | The interest rate is typically lower than the APY, as it does not account for compounding. |
| Use Case | APY is useful for comparing and evaluating the potential returns on different savings or investment products, especially when comparing accounts with varying compounding frequencies. | The interest rate is used to calculate the interest expense or earnings on loans, bonds, or other credit or debt instruments, where compounding is not typically involved. |
Example of APY vs Interest Rate
Based on data obtained by the Federal Reserve last year, the average amount of savings held by American households is $41,600 and if you are considering opening a savings account with two different banks, Bank A and Bank B. Both banks offer a 1-year savings account with an annual interest rate of 5%. However, they differ in how they calculate and advertise their returns.
Bank A:
- Annual Interest Rate: 5%
- Compounding Frequency: Quarterly (four times a year)
Bank B:
- Annual Interest Rate: 5%
- Compounding Frequency: Daily (365 times a year)
Now, let’s calculate and compare the APY and actual earnings for each bank after one year.
Bank A – Using APY:
The APY formula for Bank A would be:
APY = (1 + (0.05/4))^4 – 1 ≈ 0.050945
So, Bank A’s APY is approximately 5.09%.
Bank A – Actual Earnings:
Assuming you deposit $1,000 initially, your earnings at the end of the year will be:
Earnings = $1,000 × (1 + 0.050945)^1 – $1,000 ≈ $50.95
Bank B – Using APY:
The APY formula for Bank B would be:
APY = (1 + (0.05/365))^365 – 1 ≈ 0.051267
So, Bank B’s APY is approximately 5.13%.
Bank B – Actual Earnings:
With the same initial deposit of $1,000, your earnings at the end of the year will be:
Earnings = $1,000 × (1 + 0.051267)^1 – $1,000 ≈ $51.27
Comparison:
- Bank A’s annual interest rate is 5%, but due to quarterly compounding, it provides an APY of 5.09% and actual earnings of approximately $50.95 on a $1,000 deposit after one year.
- Bank B’s annual interest rate is also 5%, but with daily compounding, it offers an APY of 5.13% and actual earnings of approximately $51.27 on the same $1,000 deposit after one year.
In this example, Bank B offers a slightly higher APY and, as a result, a slightly higher return on your savings due to the more frequent compounding of interest, even though the nominal interest rates are the same for both banks. This illustrates the impact of compounding frequency on the APY and the actual earnings you can expect.
Which One is Important to Know for Savings Accounts?
For savings accounts, the Annual Percentage Yield (APY) is more important to know than the nominal interest rate. Here’s why:
Reflects True Earnings: APY provides a more accurate representation of the actual earnings or returns you can expect from your savings account. It takes into account the impact of compounding, which is crucial for understanding how your money will grow over time.
Compounding Frequency Matters: Different savings accounts may have the same nominal interest rate, but they can have different compounding frequencies (e.g., daily, monthly, quarterly). The compounding frequency affects the amount of interest you earn. APY factors in this frequency, making it easier to compare the real potential for growth across different accounts.
Apples-to-Apples Comparisons: When you compare savings accounts, looking at the APY ensures that you are making an apples-to-apples comparison. It considers both the interest rate and how frequently that interest is compounded, giving you a clear picture of the account’s overall performance.
Why is APY Higher Than the Interest Rate?
The Nominal Interest Rate
The nominal interest rate, often referred to as the annual interest rate or the stated interest rate, is the percentage of the principal amount (initial deposit or loan balance) that is paid as interest on an annual basis. In other words, it’s the basic rate that is advertised or quoted by financial institutions. For example, if a savings account has a nominal interest rate of 5%, it means that you will earn 5% interest on your initial deposit over a year.
Compounding Effect
The crucial factor that makes the APY higher than the nominal interest rate is compounding. Compounding is the process by which interest is calculated and added to the principal, and then, in subsequent periods, you earn interest on both the initial principal and any previously earned interest.
The Role of Compounding
The APY factors in the compounding frequency. This means it considers how often interest is calculated and added to your account. In a savings account, for instance, interest can be compounded daily, monthly, quarterly, or annually. The more frequently interest is compounded, the more you earn.
Calculating the APY
The APY is calculated to reflect this compounding effect. It considers the nominal interest rate and the compounding frequency. For our daily compounding example, the APY would be slightly higher than 5% because it captures the incremental growth from daily compounding.
Conclusion
In the world of finance, APY vs interest rate plays a central role in shaping how you save money or accumulate over time. While they share the common goal of describing financial returns, the crucial distinction is that APY considers the powerful impact of compounding. Understanding this difference is essential for making informed financial decisions, whether you’re choosing a savings account to grow your money or evaluating the true cost of borrowing through a loan.
