When you compare savings, money market or other interest-bearing accounts, you will see either interest rates or the annual percentage yield (APY) and sometimes both. What’s the difference between the interest rate and the APY? While Interest rates and APY are related, they aren’t the same. Knowing the difference is essential to understanding how much your money will earn. Read on to understand similarities and key differences.
What is an APY?
APY is the total interest you earn on an account over a year. An APY of 5% means that taking into account compound interest, you’ll earn a total of 5% interest on the money over the course of the year. While that seems like an interest rate, APY takes into account how often an account compounds throughout the year. If the account compounds monthly, a 5% APY would actually be a 4.8889% interest rate
APY will give you the most accurate measurement of interest accrued over a year on high-yield savings accounts, money market accounts, certificates of deposit (CDs) or other interest-bearing products.
What is an Interest Rate?
An interest rate is the amount of interest earned or accrued per period in proportion to the amount deposited or lent. You’ll notice that an interest rate can be for any period. It could be daily interest, monthly interest rates or annual interest rates. Interest rate is expressed in proportion to the principal sum, compounding frequency and length of time over which it is deposited.
When comparing interest rate vs, annual percentage yield, APY includes compound interest and interest rate doesn’t. Here’s an example of annual percentage yield vs. interest rate to make it clearer:
You have $1,000 in a high-yield savings account with an interest rate of 4.01%. The interest is paid after one year without compounding. At the end of the year, you’ll earn $40.10 ($1,000 x 4.01% = $40.10).
Some banks use APY instead of a simple interest rate. If the APY is 4.01%, the bank will deposit a proportional share of the interest earned each month. That means you'll earn 1/12th of 4.01% each month. At the end of the first month, you’ll earn $3.34 and have $1,003.34 in the account. That extra $3 is now also earning interest.
That means that at the end of the year, instead of $1040.10, you'd have $1041.90 because the interest compounds each month. In this example, the interest rate is 4.01%, and the APY is 4.19%.
While most people won’t worry about an extra $1.80, if instead of $1,000 in the account, you had $50,000, that would be an extra $90 a year in interest. If you want to calculate earning potential accurately, it’s important to distinguish between APY and interest rate.
What is the Difference Between APY and Interest Rate?
The difference between APY and interest rate comes down to compounding and how the calculations are done. Here’s what you need to know:
Compounding
Interest rate: The interest rate does not account for compounding. If interest is simple (non-compounding), the interest rate and APY will be the same. For example, if you have a savings account with a 3% interest rate and interest is paid out annually, the APY will also be 3%.
APY: APY accounts for compounding, which means that interest is earned not only on the initial principal but also on the interest earned in previous periods. When interest compounds more frequently (monthly, quarterly or daily), the APY will be higher than the simple interest rate.
Calculations
Interest rate: The interest rate is straightforward and represents the percentage of the principal amount.
APY: The APY calculation takes into account the interest rate, compounding frequency and the number of compounding periods in a year. The formula for APY calculation is more complex than the simple interest rate calculation.
Types of Accounts
Interest rate: When comparing different financial products, such as loans or savings accounts, you should compare the interest rates to understand the direct cost or return on your money.
APY: For comparing the overall earnings or returns on savings accounts or investments, the APY is a more accurate metric, as it reflects the compounding effect.
Using Interest Rate vs. APY
If you can, it’s always worth checking both interest rates and APY. APY will more accurately allow you to calculate annual returns because it considers compounding. The interest rate also is a useful tool that can be used, especially when looking at very short-term investments of less than a year. Learn more about average bank interest rates and the best high-yield savings accounts available.
Frequently Asked Questions
What is the difference between APY and interest rate?
The difference between APY and interest rate is in whether compound interest is considered. APY includes compound interest, and interest rate doesn’t. If the interest rate compounds annually, APY and interest rate are the same.
Are there any limitations to using APY instead of interest rates?
There aren’t limitations to using APY instead of interest rate. Some banks may only explain interest rates, so sometimes you’ll need to convert or compare both.
Are APY and interest rates fixed, or can they change over time?
Whether APY and interest rate are fixed on a particular account or financial product depends on the bank’s policies. Some accounts have fixed APY or interest rates, while others offer flexible interest rates that change with time.
About Alison Plaut
Alison Plaut is a personal finance writer with a sustainable MBA, passionate about helping people learn more about financial basics for wealth building and financial freedom. She has more than 17 years of writing experience, focused on real estate and mortgage, business, personal finance, and investing. Her work has been published in The Motley Fool, MoneyLion, and she is a regular contributor for Benzinga.