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It makes sense to shop around when choosing checking and savings accounts. You want your accounts to earn the most money when you deposit your dollars in them. But how can you calculate exactly how much money a savings or checking account, or money or certificate of deposit, will earn you?
It comes down to the annual percentage yield, or APY, of these accounts.
APY is a measurement that determines the amount of interest you’ll earn on the money you deposit into a bank account or other savings vehicle over a year.
What’s important about APY is that it includes the impact of compound interest on the earnings you make from a savings vehicle. Compound interest is interest that you earn both on the money you deposit into an account and the interest you earn over time.
This means that the higher an account’s or investment’s APY, the better. Accounts with higher APYs will earn more money over time.
When you deposit money in an interest-bearing account – such as a savings account, money market account, certificate of deposit, better known as a CD, and some checking accounts – you expect that money to grow thanks to the interest these accounts earn.
Annual percentage yield is a tool to show you just how much money your account will earn from interest during a year based on both the account’s interest rate and the number of times interest compounds during the year.
How often interest is compounded matters when you’re choosing a savings account or other investment vehicle. Accounts that pay interest more frequently will generate more money each year than will those that do so less frequently.
Banks can choose to pay interest whenever they’d like. Most, though, go with one of four options.
Some accounts will compound interest annually. This means interest is calculated and paid out once a year. Others will compound interest quarterly, meaning interest is calculated and paid out once every three months.
Accounts that compound interest monthly will calculate and pay out interest each month. And those that compound interest daily will calculate and pay out interest each day.
This is why APY is so important. You might think an account will pay out more because its interest rate is higher than another’s. But if that second account compounds interest more frequently, it might actually pay out more throughout the year.
When comparing savings accounts, money market accounts, checking accounts, CDs and other investment vehicles, then, compare their APYs, not only their interest rates.
If you’re in the mood for a little math, you can calculate the APY on any bank account using this formula: APY = (1+r/n)n – 1.
In this equation, “r” stands for the listed annual interest rate as a decimal. If the interest rate is listed as 0.04%, you’d insert it as 0.0004 in the formula. The “n” represents the number of compounding periods during the year.
Fortunately, banks will usually advertise the APY of their savings accounts, money market accounts and CDs, meaning that you won’t have to calculate this figure on your own.
But if you’d like the practice, here’s an example of how to calculate APY. Say you are considering a savings account with a listed interest rate of 0.06% that compounds once every month, or 12 times a year.
The APY formula for this savings account would look like this: APY = (1+0.0006/12)12 -1. Remember, when converting the interest rate of 0.06% to a decimal, it comes out to 0.0006. The “12” in this equation is the number of times a year that interest on this account compounds.
After running these numbers through the formula, you get an APY of 0.060017%.
You can then determine how much this APY will earn you during a year. To do this, though, you’ll need a new formula, one that includes the amount of principal you have in your account.
The formula for determining how much you’ll earn with a particular APY looks like this: (APY x principal) + principal = total earnings after a year.
In our example, let’s say you have an $80,000 principal balance in your savings account. The APY, remember, we’ve already calculated to be 0.060017%. Plug those numbers in our formula and you’ll see that your principal balance will increase to $80,048.01. This means that your APY will have generated $48.01.
That might not seem too impressive of a return. But maybe you invest your money in a 12-month CD that earns a higher 0.26% APY.
If you plug your principal balance of $80,000 and your 0.26 APY into the yearly earnings formula, you see that your principal balance after a year will rise to $80,208.04. The CD’s APY, then, will have earned you $208.04 in compound interest during the year.
Compounding interest is important when considering an investment vehicle because it means that the interest you earn from your account grows at a faster pace.
Compounding might not seem overly significant during a single year. But if you hold onto your account or investment vehicle for several years, these small increases can add up.
When looking at investment vehicles, then, remember that it’s best when accounts or investments compound more frequently.
How often interest compounds depends on the specific investment vehicle. The interest on a savings account might compound on a daily or monthly basis. Other investment accounts might compound their interest twice a year or every three months.
The bottom line? You’ll gain more interest if your account compounds interest more frequently.
Accounts can have either a fixed or variable APY. A fixed APY, as the name suggests, doesn’t change. It remains the same on the day you open your account and the day you close it.
A variable APY, though, can change at any time. Most checking, savings and money market accounts come with variable APYs. CDs, though, usually come with a fixed APY for their terms.
Variable APYs usually rise according to certain benchmark interest rates. When the Federal Reserve raises or lowers its interest rate, for instance, the variable APYs on savings or checking accounts will typically rise or fall, too.
You might also hear the term APR. Don’t get it confused with APY. APR, which stands for annual percentage rate, is the numerical representation of what you’ll pay for a loan.
Say you take out a mortgage loan. Your APR would include that loan’s interest rate and all the fees you’ll be charged by your lender and third-party providers. APR, then, is a more accurate representation of how expensive a loan really is. The lower your loan’s APR, the less you’ll pay for borrowing money.
The big difference between APR and APY? APY illustrates how much you’ll earn from a savings account or other investment. APR tells you how much you’ll pay when borrowing money.
When looking for a savings vehicle, search for ones that have the highest APYs. You’ll earn the most interest on these investments.
But what makes for a good APY? The FDIC in October of 2021 said that the national average APY for savings accounts was 0.06%. That figure stood at 0.08% for money market accounts and 0.14% for 12-month CDs. Any APY you can get higher than those figures would rank as a good one.
Savings and some checking accounts have APY attached to them. So do money market accounts and CDs. Again, the higher the APY on these accounts, the higher your earnings.
Loans, though, come with APR. You’ll see APR listed with such loans as mortgages, auto loans, student loans and personal loans. Credit cards, too, come with APR. But the APR on credit cards is the same as their interest rate because you don’t pay any additional fees for credit cards.
The lower your APR on these loans, the less you’ll pay to borrow money.
When shopping for savings vehicles, don’t look only at the interest rates quoted to you by banks or other financial institutions. Instead, check the investment’s APY, which is a more accurate reflection of how much you’ll earn from your savings.
And if you’re taking out a loan? Don’t rely only on quoted interest rates, either. Compare loans by comparing APRs, something that gives you a more accurate representation of how much a loan will cost you.
Be sure to learn more about APR and APY from Rocket Mortgage®.
Dan Rafter has been writing about personal finance for more than 15 years. He’s written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, RocketMortgage.com and RocketHQ.com.