When you\u2019re signing up for a checking or savings account, the first thing you are likely to review is the account\u2019s APY and interest rate. They may seem similar but they are actually two very different terms.<\/p>\n\n\n\n
An interest rate is the percentage of your deposit that banks pay you in order to hold your money with them. APY is an acronym that stands for annual percentage yield. It refers to the total amount of interest you earn on your savings over a year, and it factors in compounding interest. APY gives a truer picture of how much money you will make from your certificate of deposit (CD), savings or money market account, than by looking at a simple interest rate alone.<\/p>\n\n\n\n
The higher the APY, the more money you can expect to earn from your deposit in your CD, money market or savings accounts.<\/p>\n\n\n\n
For deposit accounts, there are two types of interest rates you need to know: simple interest and compounding interest.<\/p>\n\n\n\n
Simple interest is easy to calculate \u2014 it\u2019s calculated only on the principle you deposit in your bank account. It means if you invest $10,000 at an interest of 2%, for instance, you will earn $200 in interest at the end of the year.<\/p>\n\n\n\n
Simple interest rates are typically used with brokered CD accounts purchased through brokerage firms like Fidelity, Vanguard or Charles Schwab, said Ken Tumin, founder and editor of DepositAccounts.com, a fellow LendingTree-owned site. Instead of receiving compounding interest, holders of brokered CDs normally get paid simple interest monthly, quarterly, semi-annually or annually.<\/p>\n\n\n\n
Compounding interest is more complicated, because it takes into account the interest you earn on both the interest and principle. When you leave the interest you earn in a bank account instead of taking it out, the overall interest paid is calculated based on the total balance, including the interest you\u2019ve earned over time. So as each month passes, you are earning interest on an increasingly larger pool of money.<\/p>\n\n\n\n
That\u2019s why compounding interest can be such a powerful tool and why you\u2019ll hear many experts encourage folks to save as early and often as they can so that they have more time to enjoy the power of compounding.<\/p>\n\n\n\n
Here is how compounding interest works. Let\u2019s say you put $10,000 in savings account that earns an interest rate of 2%. After one year, you will have earned $200. So you\u2019ll start year two with a total balance of $10,200. Now, you\u2019ll earn the same 2% but you\u2019ll be earning it on a higher balance (your original deposit plus $200 in earned interest). At the end of year two, the total interest on your deposit will be $204 \u2014 ($10,000+$200) x 2% = $204 \u2014 and you\u2019ll be left with a total of $10,404.<\/p>\n\n\n\n
Most deposit accounts where you earn the interest use APY. It is a number that accurately represents how much you will make from a deposit in a given year, factoring in both the interest rate and compounding period.<\/p>\n\n\n\n
If interest is paid on an investment once per year, which means it has an annual compounding period, as shown in the above-mentioned example, the APY and interest rate are the same.<\/p>\n\n\n\n
But in reality, most banks offer more frequent compounding periods, which could be quarterly, monthly, weekly or even daily. In these situations, the compounding effect occurs on a much smaller scale but more frequently. As a result, the returns are higher.<\/p>\n\n\n\n
Most banks offer an APY, so that account holders don\u2019t have to calculate on their own. But if you are curious to know how an APY is calculated, the Federal Deposit Insurance Corporation (FDIC) provides the mathematical formula<\/a> on its website.<\/p>\n\n\n\n Read more about the difference between APR and interest rate when it comes to mortgages here<\/a>.<\/em><\/p>\n\n\n\nHow to calculate APY<\/strong><\/h2>\n\n\n\n