This three-letter acronym is a super important concept for upping your money management game: APY. It stands for annual percentage yield, and grasping why it matters and how it grows your wealth is key. In short, APY represents how much profit you earn on the cash you keep in your bank accounts.
“APY is especially significant during life periods where liquidity and risk avoidance are critical, such as when starting an emergency fund or approaching retirement,” says Chad Harmer, financial planner and founder of Harmer Wealth Management in Ontario. “Younger people should prioritize balancing APY with growth-oriented investments, as bigger returns are often required to achieve long-term objectives.”
If you’ve had a sinking feeling in your bank accounts recently, you’re not alone: According to the Federal Deposit Insurance Corp. (FDIC), the average APY on U.S. savings accounts is a mere 0.42%. You can do so many things to beat this dismal figure, maximize the APYs you earn across your bank accounts, and change your financial life. We’ll show you how.
What is APY? How does it work?
It’s helpful to understand what APY is by contrasting it to another commonly used financial term: simple interest. The two terms are often referenced together and it’s easy to confuse them, but they have distinct meanings.
Simple interest is the fixed return on a deposit that a financial institution like a bank or a credit union pays you each year, expressed as a percentage. It’s simple: If you deposit $100 in a bank account that carries a 1% interest rate, you would earn $1 on that deposit in one year.
Annual percentage yield factors the impact of compound interest on your earnings. A bank adds the simple interest you earn on your deposit into the account on a daily, monthly, or quarterly basis. This mechanism gradually grows the balance on which you earn interest—or rather, you earn interest on your interest.
If your deposit account compounds monthly, that means the bank adds 12 interest payments to the account balance over the course of one year. The interest rate earned on the balance remains fixed, but the total balance increases 12 times as each batch of earnings is compounded—that is, added to the account—boosting your annual yield.
The impact of compounding can yield impressive growth. If you deposited $10,000 into a savings account with a 5% APY and didn’t touch it for a decade, after ten years you’d have a balance totalling $16,486. With simple interest, you’d only have $15,000.
APY are not static, here is why they change constantly
Banks and credit unions advertise widely varying APYs on different types of deposit accounts, making it essential to shop around for the best rates. The best APYs available in the market typically come with high-yield savings accounts and long-term certificates of deposit.
Another fact to keep squarely in mind: Banks can and do change the APYs offered on different deposit accounts all the time. There’s no guarantee that the killer rate you got when you signed up for a savings account last year will last, since the interest rate environment is dynamic.
Changes in deposit account APYs are dictated by financial institutions’ appetite for deposits and the overall economic environment. But more than any other factor, they are determined by the monetary policy of the U.S. Federal Reserve.
The nation’s central bank changes the federal funds rate to help cool down the economy when it’s overheating, or revive economic activity when a recession strikes. Either way, when the Fed raises or lowers interest rates, banks respond by changing the APYs on deposit accounts.
“In the current rate environment, investors should expect an APY for savings accounts and money markets around 4%. One-year CDs should be between 4.00-4.50%, and 5-year CDs should be around 4.25-4.75%,” says Tim Witham, CFP with Cincinnati-based firm Balanced Life Planning.
Let’s do the math: What’s the formula to calculate APY?
Another way of defining APY is that it represents the real rate of return you can earn in one year if interest is compounded. And the more often interest is compounded, the higher the APY will be. Here’s how the math looks:
APY = (1 + r/n)n – 1
The r in the equation refers to the rate, or interest rate, and the n refers to the number of compounding periods within a year.
So if you wanted to put $3,000—with no additional deposits—into a high-yield savings account earning 2% that compounds monthly (12 periods within a year), the APY formula would look like this.
(1 + .02/12)12 -1 = 0.020184
To make it a percentage, multiply that number by 100 and you get 2.0184% APY.
With an initial deposit of $3,000 you can multiply that amount by the APY ($3,000 x 2.0184%) and see how much your money would grow within the year. Given the APY calculation, you’d have $3,060.55 at the end of the year, so you’d earn a little over $60 in interest.
The good news is, you don’t have to understand the formula to take advantage of it—banks are required to display the APY on their deposit products for consumers to see.
APR vs. APY: What’s the difference?
There’s another three-letter acronym that is frequently compared to or confused for annual percentage yield: APR. It stands for annual percentage rate, and it’s typically used to describe the cost of borrowing money via personal loans, credit cards, or mortgages.
APR is a percentage that represents the annual cost of a loan, but it’s a bit different than simple interest. That’s because it also factors in costs associated with a loan, such as fees, but it never takes compounding into account. APR gives you a concrete view of what you'll pay every year, making it simple to compare offers among lenders.
Credit card issuers charge various APRs on different sorts of charges. The main APR is levied on purchases, and there are typically higher APRs for balance transfers and cash advances, as well as even higher penalty APRs on late payments. Issuers offer cards with a 0% APR for an introductory period, frequently called balance transfer cards , to entice new customers.
Compare your APY to inflation to understand your real return
In order to grow your wealth, you need to understand the impact of inflation on your money. When it comes to bank deposits, you need to choose accounts with APYs that are higher than the prevailing rate of inflation. Otherwise, the gradual upward creep of prices will erode your wealth and purchasing power.
“For example, if inflation is 3% per year and your savings account yields 2% APY, you are basically losing purchasing power,” says Harmer. “True growth happens when the APY exceeds the inflation rate, which has proven difficult in recent years for low-risk savings vehicles. During periods of strong inflation, it is vital to consider higher-yielding options such as CDs, I-bonds, or dividend-yielding assets.”
Consider all your options. Lock some money away in a short-term CD, don’t be afraid to open multiple high-yield savings accounts for your emergency funds so you can easily swap between who has the current highest rate, and don’t ignore tax-advantaged options for retirement and other long-term financial planning.
