If you’re looking for a new savings account, you’ll likely come across the terms annual percentage yield (APY) and interest rate. But what’s the difference between the two? They might sound similar to most people, but there are significant differences. Understanding APY vs. interest rate will help you accurately calculate the return you can earn from your savings account.

Keep reading as we explore the differences between APY and interest rate and provide an example of the two.

APY and Interest Rate Defined

When you put money into an interest-bearing account, you’ll earn an annual percentage yield (APY) on your balance. APY is important because it shows how much interest you could earn over a year, expressed as a percentage. APY is more than just the interest rate on your deposit account. It’s also going to consider if the bank will compound interest and at what frequency.

Understanding APY is a more accurate way to compare savings accounts, CDs and other deposit accounts that earn interest.

Also Read: Best CD Rates

What is APY?

APY, or Annual Percentage Yield, shows how much your money will grow in a year, including compound interest. Unlike interest rate, which only tells you how much you’ll earn before the affects of compounding, APY gives a clearer picture of your actual returns.

The more often interest compounds, daily, monthly or yearly, the higher your APY will be. That’s why banks and credit unions use APY to help you compare savings accounts, CDs, and other deposit accounts that earn interest. Simply put, APY is the best way to see the true earning potential of your money and make smarter financial decisions.

What is an Interest Rate?

The interest rate is the basic percentage a bank will pay on your savings account. However, it doesn’t tell the whole story of how much you’ll earn. Unlike the APY, which factors in compounding, the interest rate only reflects the raw rate of return before any compounding effects.

This means that if two accounts have the same interest rate but different compounding frequencies, their APYs will be different.

APY vs. Interest Rate: What’s The Difference?

When comparing high-yield savings accounts and CDs, understanding the APY gives you a better idea of how much total interest you can earn. Because APY includes compound interest, you’ll understand exactly how much interest you’ll earn based on how frequently your bank compounds interest.

What’s The APY Formula?

If you want to learn more about how the annual percentage yield is calculated, the formula is below.

(1 + r/n)ⁿ – 1

The “r” represents the interest rate an account earns.

The “n” is the number of compounding interest periods within a year. If interest compounds monthly, this would be 12. However, if it compounds daily, it would be 365.

If you compare two savings accounts, money market accounts or CDs with the same interest rate, one might yield more interest. The reason is the frequency with which interest is compounded.

APY vs. Interest Rate Example

Let’s look at an example to give you a clear picture of how APY and interest rates differ.

Suppose you deposit $10,000 into a savings account with a 3.75% interest rate. If that account paid out simple interest, you would earn $375 after one year ($10,000 x 3.75%).

Now, let’s assume you deposited the same $10,000 in a different account that also paid 3.75%. However, this account compounds interest monthly. That means, after one month, your $10,000 would have earned 1/12 of 3.75% or 0.3125%. The value of your savings account after one month would be $10,031.25.

Because of using a compound interest rate, the interest during month two would be based on your $10,031.25. That means after month two, your account balance would be $10,062.60 ($10,031.25 x 0.3125%).

With monthly compound interest, the account’s value after 12 months would be $10,381.51, slightly higher than the value of the account paying simple interest.

Also Read: Best Bank Account Bonuses

Is Interest Rate or APY Important to Know For a Savings Account?

When looking at different interest-bearing accounts, whether they are traditional savings accounts at a bank or credit union or an online high-yield savings account, they require APY to be listed. However, some are also going to list the interest rate.

Understanding the APY vs. interest rate for the accounts will help you truly understand how much interest you can earn over a year.

Compound Interest Calculator

Want to understand how much a particular account will help you earn? Plug the numbers into our compound interest calculator below.

The Bottom Line

When a bank account lists its APY, it factors in compound interest, or the ability to earn interest on your interest. Make sure you’re comparing APY and not just interest rate, as this will give you a better idea of how much interest you could earn from any interest-earning bank account.