APY vs. Interest Rate: Understand The Differences
Written by
John Csiszar
Edited by
River Jean-Noel
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The terms “APY” and “interest rate” are often used interchangeably when people discuss savings and investments, but there’s a very important distinction between the two. While it’s important to understand both terms, APY is the one that most people will find most useful in terms of the return they expect to receive. To fully understand the distinction between the two, here’s a look at how each is defined, how they relate to one another and how to use them when researching investments.
What Is APY?
APY, or annual percentage yield, is the amount of money that you will receive on an investment over the course of a year. APY assumes that you are reinvesting the dividends or interest payments you receive along the way, so it is a compound rate.
What Is Interest Rate?
Interest rate is the flat, actual payout that you receive on your investment from month to month, quarter to quarter, or year to year, as the case may be.
If you invest in a savings account that offers a 5% interest rate, you’ll earn a flat 5% on your account balance every month. If you take out your interest payments as you receive them, this means you’ll receive the same amount every month, with no compounding.
What Is the Relationship Between Interest Rate and APY?
Interest rate is a component of APY. Interest rate is the rate at which you earn money on your account balance, while APY reflects the actual total return you’ll earn over the course of a year if you reinvest your interest payments. Here’s an example to make the difference clear.
Imagine you put $1,000 into a savings account that pays an interest rate of 5%. The first month, you’ll receive an interest payment of $4.17, which is 1/12 of the $50 you’ll earn annually. If you take that interest payment out as cash, you’ll receive the same $4.17 monthly payment the following month, and the month after that, and so on.
However, if you reinvest that interest payment, your balance will steadily increase. As you’ll be earning the same 5% interest rate on your entire account balance, your monthly payment will actually increase over time, even though your interest rate will stay the same.
For example, imagine in the above example you reinvest your interest payment every month. After the first month, your account balance will be $1,004.17. Earning 5% on that amount will generate an interest payment of $4.18, pushing your value up to $1,008.35. Over the course of a full year, if you reinvest your interest payments every month, your year-end account value will be $1,051.
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If you had not reinvested your interest, you would have only received $50 in annual interest payments. But by reinvesting, you earned an extra dollar. This extra dollar represents your APY. While your interest rate was a flat 5%, your APY on that account was actually 5.1%.
Which One Is More Important to Investors?
The APY on your account will be higher than the interest rate because it represents your total return, including compounding. As most investors reinvest the income they receive in their savings accounts, APY is generally more relevant.
However, if you invest in bonds, which make fixed, semi-annual payments that don’t generally allow reinvestment or compounding, the stated interest rate is more relevant.
How To Calculate APY
Calculating APY involves using a standard mathematical formula. While you can always get the APY from your bank or credit union simply by asking, here’s the process if you want to calculate APY for yourself:
Formula to Calculate APY:
APY = (1 + r/n)n – 1
r = interest rate
n = number of compounding periods — daily compounding interest would be 365
When calculating APY for a compound interest account, you need to consider the number of compounding periods. For example, a typical interest account will have interest calculated once per year, but some accounts will calculate interest multiple times per year. You can find the APY of your account by multiplying the stated interest rate by the amount you have in the account.
For example, suppose you have $5,000 in a CD account with a 5% interest rate. If it’s compounded monthly, the formula will look like this:
APY = (1 + 0.05/12)12 – 1
APY = 5.13%
To find out how much money you’d have at the end of the year, multiply your initial deposit by the APY. In this case, your final account balance would be $5,255.81, when account balances are compounded monthly.
Example of the Long-Term Benefit of Compounding
Although the above examples show the difference between APY and interest rate, they don’t tell the whole story. The difference is particularly striking the longer that you remain invested, and the higher return you earn.
The S&P 500 stock index, for example, has returned an average of about 10% annually over the long run. If you were to invest $10,000 at a 10% average annual return, you’d earn $1,000 per year. If you did not reinvest those gains, over a 40-year period, you would earn $40,000, or $1,000 x 40 years. This would give you a total account value of $50,000 after the 40-year period. If you were to reinvest your gains and compound them over those 40 years, however, your account value would be closer to $537,000, or more than 10x as much.
It’s true that it has been a long time since savings accounts have yielded 10% annually, and they may never reach those levels again. But the above example, using the S&P 500 index as a proxy, shows just how powerful the effects of compounding can be over long periods of time.
If you used the same example with a 5% return, the results wouldn’t be as dramatic, but they’d still show how APY can greatly exceed interest rate. Under those parameters, you’d earn $500 per year, or $5,000 over the 40 years using the simple interest rate, for a total value of $15,000 — but if you reinvested all interest, you’d end up with $73,584, or nearly 5x as much money.
Melanie Grafil contributed to the reporting of this article.
