Published in: Banks | March 18, 2019

What Is APY and What Does It Mean for Your Savings Account?

APY and interest rate are two different financial concepts, so here’s what you need to know.
White note cards with various percentage numbers on them.

Image source: Getty Images.

If you’ve been shopping around for a savings account, interest-bearing checking account, or a certificate of deposit (CD), you may have noticed that banks advertise each account’s APY. While many people use the term APY as a substitute for “interest rate,” the reality is that the two terms have different meanings. With that in mind, here’s a primer on APY, what it means to your savings account, and how to find a savings account that will give you the best APY.

What is APY?

APY stands for annual percentage yield and is a commonly-used way to describe the returns paid by your savings account, as well as your interest-bearing checking accounts and certificate of deposit (CD) accounts. Essentially, APY is the return you can expect on your money after leaving it in the account for one year.

As a simplified example, let’s say that you have $10,000 in a savings account and that your APY is 2%. This means that after one year, your balance should increase by 2%, which would give you a total of $10,200 in the account. If you deposit or withdraw money during the year, or if your account’s APY changes, the calculation gets a bit more complicated, but this is the basic idea of how it works.

APY vs. interest rate

The terms APY and interest rate are often used interchangeably, although they do have substantially different meanings, especially when it comes to savings accounts.

Savings account interest is compounded rather frequently -- usually daily or monthly -- and is typically posted to the account every month. In other words, if the first month’s interest posts, the second month’s interest will be computed using the new, higher balance. Each month, your balance will go up a little bit because of the interest that was paid, and the next month’s interest will be paid on not only your original balance, but the interest that has accumulated as well.

APY is the annual effect of this compounding, while your account’s interest rate is the nominal rate used in daily (or monthly) interest calculations. Generally speaking, your account’s interest rate is lower than the APY (but close), because of the compound interest effect.

To be clear, most banks only advertise APY when it comes to interest-bearing deposit accounts. The nominal interest rate is a number that is simply used to calculate your earned interest on a short-term basis.

Compound interest and APY

If you’re confused by the explanation in the last section, it may help to consider an example. Let’s say that you deposit $1,000 in a savings account that pays 2% interest, compounded and paid monthly. So, each month, 2% of your balance is calculated, and one-twelfth of that amount is posted to your account.

In the first month, this would mean that about $1.67 in interest would post to your account, making your balance $1,001.67 at the start of the second month. Now, interest would be calculated based on that new, higher balance. Here’s how your savings account’s balance would grow over the course of a year:

Month

Starting Balance

Interest Paid

Ending Balance

1

$1,000

$1.666667

$1,001.67

2

$1,002

$1.669444

$1,003.34

3

$1,003

$1.672227

$1,005.01

4

$1,005

$1.675014

$1,006.68

5

$1,007

$1.677806

$1,008.36

6

$1,008

$1.680602

$1,010.04

7

$1,010

$1.683403

$1,011.73

8

$1,012

$1.686209

$1,013.41

9

$1,013

$1.689019

$1,015.10

10

$1,015

$1.691834

$1,016.79

11

$1,017

$1.694654

$1,018.49

12

$1,018

$1.697478

$1,020.18

Data source: Author’s own calculations.

Here’s the key takeaway. Your nominal interest rate is 2%, and simple math tells us that 2% of your account’s balance would be $20. However, you see that your account’s balance has actually increased by $20.18 thanks to the effect of compound interest, which translates to an APY of roughly 2.02%.

The long-term compounding power of APY

The most important concept to understand about compound interest is the long-term effect it can have on your savings. For example, let’s say that you open a $10,000 five-year CD with an APY of 4% with money that you’ve set aside to help with your 13-year-old child’s college tuition. With just five years to go until college age, you don’t want to take the risk involved with stocks or other investment vehicles, so a risk-free deposit account can make sense. (Note: I’m using a CD because they have fixed APYs for their entire term, so it’s easier to predict long-term results. However, the same concept applies for savings accounts.)

Here’s how your account would grow over time:

Year

Start

Interest

End

1

$10,000

$400.00

$10,400.00

2

$10,400

$416.00

$10,816.00

3

$10,816

$432.64

$11,248.64

4

$11,249

$449.95

$11,698.59

5

$11,699

$467.94

$12,166.53

Data source: Author’s own calculations.

Each year the 4% APY would be applied to higher and higher balances. So, 4% times five years would translate to a 20% return, but your CD would have grown by 21.7% thanks to the power of compound interest.

How savings account APY changes over time

One important thing to know about savings accounts is that the APY can (and probably will) change over time. This is a common misconception -- in other words, just because your savings account has an APY of 2% when you open it doesn’t guarantee that the APY will stay that way for any length of time.

In practice, savings account interest rates generally rise and fall with other benchmark interest rates such as the prime rate, however there is no direct correlation. In other words, there’s no rule that says your savings account interest rate has to rise and fall proportionally, or at all, along with any other rate. In fact, savings account APYs typically rise a little slower than market interest rates.

Finding the best APY for your savings

You might be surprised at the wide variety of APYs paid by savings accounts, especially those offered by different types of financial institutions. As of Jan. 25, 2019, the national average savings APY is a paltry 0.09%, but this is disproportionally weighed down by traditional (branch-based) national banks, many of which still offer savings APYs of as little as 0.01%. Meanwhile, smaller local and regional banks often offer higher-than-average APYs, as do credit unions.

For the best APYs, you’re probably better off looking into an online-based savings account. Over the past few years, several reputable financial institutions have begun offering online savings accounts. Marcus by Goldman Sachs, Synchrony Bank, and Ally Bank are just a few examples. Deposit accounts offered by these institutions are FDIC-insured, just as with branch-based banks.

However, because they don’t have the additional costs that come with operating a network of branches or ATMs, these institutions are able to pass some of the savings on to their customers in the form of lower fees (often none at all) and higher APY. For context, there are APYs as high as 2.25% offered by the best online savings accounts as I write this -- that's 25 times the national average.

While I can’t check the APYs offered by every regional and local bank, or every credit union, I can definitively say that if you want a great APY from your savings, checking the best online savings accounts is a good place to start your search. While I certainly don’t want to discourage you from checking with some of your local financial institutions, there’s a good chance that even the best branch-based savings account APYs won’t measure up.

Savings account rates are skyrocketing -- Earn 23x your bank

Many people are missing out on guaranteed returns as their money languishes in a big bank savings account earning next to no interest. Our picks of the to uncover the best-in-class picks that landed a spot on our shortlist of the best savings accounts for 2019.