Generally, a higher APY means higher returns on your deposits, whereas a lower APY means you’ll earn less. Our best online banking services often have APYs above 4% and low fees that won’t erode your interest earnings.
Here's what to know if you’re curious about how APYs work, what they mean for your savings, and how they differ from interest and dividend rates.
What Is APY?
Understanding Compound Interest First
To understand how APYs work, it’s important to first understand the concept of compound interest. With compound interest, you earn interest on your initial balance, and those interest earnings are added to your balance. You then earn additional interest on the new balance. Depending on your bank, interest may compound daily, monthly, quarterly, or annually.
Getting to the Bottom of APY
APY tells you what percentage you can earn on a savings or investment account over a year, including all that compound interest. Let's say you make a $5,000 deposit into a savings account with a 4.75% APY and interest on that account compounds daily.
In this example, you’d earn $19.83 in interest during your first month, which would then be added to your $5,000 initial deposit. The next month, you’d earn interest on your $5,019.83 balance, and your interest earnings would be slightly higher than the previous month’s—$19.91.
This amount would be added to your balance, and the process would repeat itself. This cycle continues, and if you don’t touch your money for a year and make no further deposits, your balance will grow to $15,243.21.
You'll notice different APYs offered from bank to bank. That's because each bank sets its rates with a strategy in mind, aiming to attract customers by offering the right mix of solid returns, reasonable fees, and dependable service.
How Is APY Calculated?
Your bank calculates your account’s APY using a simple formula:
APY = ( 1 + r ⁄ n ) n – 1
r = annual interest rate
n = annual compounding periods
So let’s say your savings account has a 4.5% interest rate, which compounds monthly. If we plug our numbers into the APY formula, it’ll look like this:
APY = ( 1 + .045 ⁄ 12 ) 12 – 1
Our APY would be 0.0459 or 4.59%, slightly more than our 4.5% interest rate.
Why Is APY Important?
Since your account’s APY factors in compound interest, it gives you a sneak peek of what you’ll actually earn on a deposit or investment account. This makes it a good factor when choosing between the possible investment options. Usually, the higher your APY, the higher your account’s earning potential, and vice-versa. So it’s a good idea to compare APYs if you’re shopping for a new savings, checking, or certificates of deposit (CD) account.
For context, many high-yield CDs and savings accounts offer APYs higher than 4%. While some checking accounts also earn an APY, these APYs are quite modest, often as little as 0.10% or 0.25%.
APY vs. Interest Rate: What’s the Difference?
While APYs and interest rates might be similar, they differ in how they account for interest earnings. Think of your interest rate as calculating simple interest based only on your initial deposit. For instance, if you put $5,000 in an account with a 4.5% simple interest rate and don’t make any subsequent deposits, you'd get $225 after a year.
An account's APY gets into the details by considering compound interest, which stacks your earnings on top of your initial deposit and any interest you’ve already earned. The result is that your account’s APY provides a more accurate depiction of your potential annual earnings. This compounding effect can significantly increase your APY, particularly if it happens more frequently—like monthly instead of annually.
Both interest rates and APYs on savings and other deposit accounts can increase or decrease over time. Banks set their rates, which are largely influenced by the federal funds rate, which the Federal Reserve sets eight times yearly. Per the Federal Reserve, “The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.”
APY vs. APR
Annual percentage yield (APY) and annual percentage rate (APR) might sound similar, but they play very different roles. APY is about what you earn on savings accounts—it's your gain. APR represents the interest you pay on a loan or credit line, including other costs like origination fees, closing costs, underwriting fees, and broker fees.
For example, your credit card company will assign you an APR when they issue you a new card. Credit cards often have higher APRs than other types of financing, including mortgages, personal loans, home equity loans, and auto loans. You need to understand how interest rates and APR are calculated since you might see a credit card APR of 20% or more, while many other lending products have APRs in the 6%-14% range.
Another key difference is that your credit can impact your APR. Generally, the lowest APRs for loans and credit lines are reserved for borrowers with the highest credit scores. But with APY on your savings, everyone gets the same deal, no matter their credit score.
Dividend Rate vs. APY
You might also see dividend rates mentioned in two contexts: at credit unions and on certain investments. “Most credit unions call the money it pays you for keeping your money on deposit at the credit union a dividend,” according to mycreditunion.gov. It’s the same as a bank’s interest rate, just with a different name. Following our earlier example, if your dividend rate at a credit union is 4.5% and interest is compounded monthly, your APY would be 4.59% for the same account.
Some stocks also pay dividends, a percentage of a company’s profits distributed back to shareholders. Depending on the company, dividends can come monthly, quarterly, semi-annually, or annually. It’s common for companies to pay dividends as cash, but some also pay stock dividends, which are paid out as additional company stock.
What APY Means for Bank Accounts
So we’ve established that the higher the APY, the more you’ll earn from your bank account. For example, a 4.5% APY can yield higher returns than a 3.5% APY, depending on the terms and compounding frequency. However, while APY is an important consideration when choosing a bank account, you shouldn’t consider this factor alone.
You’ll need to look at potential account fees, including monthly maintenance, overdraft protection, and other fees. That’s because if a particular bank has high fees, it could eat into your earnings from a high APY. You may be better off looking for a no-fee bank that offers a slightly lower APY instead.
How To Find the Best APY for You
You can take several approaches to find the most favorable APY. Here are some strategies to consider:
Know the inflation rate. Consider the current inflation rate to compare it to APYs on prospective accounts. Ideally, you want an APY that exceeds the current inflation rate so your earnings can outpace inflation.
Make an independent comparison. You can compare APYs from individual banks, credit unions, and online lenders on your own.
Consider online banks. Online banks tend to have fewer overhead costs, so they can offer higher APYs than brick-and-mortar financial institutions.
Watch the compounding frequency. A higher APY is great, but also check how often interest compounds. Daily or monthly compounding can boost your earnings, especially if the rate is close to others.
Consider other factors. Yes, a high APY is important, but you’ll also want to research account fees and other features, like whether a particular bank offers a helpful mobile app or accessible ATMs.
Factors That Influence APY
As mentioned earlier, interest rates and compounding frequency factors are included in APY, but bigger market forces also come into play.
Banks and credit unions set their own rates, and competition between them can have a big impact. However, the biggest influence comes from the federal funds rate. This is the rate banks use to borrow and lend to each other. When the federal funds rate drops, deposit account rates usually follow, making it cheaper for borrowers to take out loans or credit. When it rises, the opposite happens.
The Federal Reserve sets the federal funds rate eight times a year. It typically reduces its benchmark rate to encourage consumer spending, and there's little concern about inflation. When it wants to rein in consumer spending and the inflation rate is concerningly high, it typically increases its benchmark rate, which we saw in 2022 and 2023.
Bottom Line
APY gives you a clearer picture of what you can actually earn from your savings or investment accounts, unlike basic interest or dividend rates. While a higher APY often means better returns, it’s important not to focus on that alone. Consider the full picture, like account fees and whether the account fits your needs. This approach can help you make an informed choice tailored to your financial goals.
