Have you ever seen an advertisement or promotion that mentions APY, and you really don’t understand what that means?
If you’re considering taking out a certificate of deposit (CD), interested in high-interest checking, or just curious, it’s worth taking a deeper look into the relationship between annual percentage yield (APY) and the interest rate on any given deposit account. To do so, we’ll give you the basics and then use some math to help explain why the distinction between APY and interest rate can end up making a big difference for your finances.
Interest and interest rates
Simply put, interest is money charged on the balance of a loan. Most of us have personal experience with paying interest, whether on a loan, a credit card, or other kinds of debt. But you can also earn interest on the balance of a deposit account or product, such as an interest-bearing checking account, savings account, or a CD, since you’re essentially loaning your money to a financial institution. For the remainder of this article, we’ll assume you’re earning interest in this way, rather than paying it as part of a loan.
Interest is written as a percentage, which refers to the amount that is earned on the balance of a deposit account during a given cycle. Many accounts earn interest once per year, while others have more frequent interest cycles.
In most cases, interest isn’t just earned on the starting balance of an account (a.k.a. simple interest). When it comes time for interest to be calculated, it accumulates on top of previous interest earned – a process called compounding.
Compound interest and annual percentage yield (APY)
To illustrate how compound interest is preferable to simple interest, we’ve created a graph using the Hills Bank High Interest Checking Account as an example. With no minimum balance, qualifying account holders earn 3% interest on their balance, which compounds once per month. That means the actual amount of money deposited into the account each month is calculated by applying the interest rate to the balance of the account, then dividing by 12 (for each month of the year).
Though the difference is subtle in the first few years, over time the growth you’ll see from compound interest clearly outweighs that of simple interest. Consider a 10 year timeframe at a 3% interest rate:
Once compound interest is factored in, these High Interest Checking Accounts that we’ve used as an example can achieve an annual percentage yield (APY) of 3.04%. Because APY takes compound interest into account, it gives you a more accurate estimation of the amount of interest you’ll earn over a year in most deposit products.
And there you have it! If you’ve ever wondered why financial institutions like Hills Bank talk about annual percentage yield rather than interest rates, we hope you’ve found this article helpful.
Now that you’re an APY expert, why not take a look at our interest and APY rates for deposit accounts?