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If you want to understand how much interest you can earn on your money, you’ll want to pay close attention to your bank account’s annual percentage yield, or APY.
Annual percentage yield is a fancy name for the rate of return you get on your money after accounting for compounding interest. Depending on your bank, your interest may compound at different time periods. While one bank may compound interest daily, another bank may only compound monthly. The more frequently your interest compounds, the higher your APY.
To calculate annual percentage yield, you’ll need to do a little math. APY is calculated using the following formula:
r = the annual interest rate
n = the number of times interest compounds per year
Thankfully, you don’t have to memorize this formula because banks are required to provide — and often advertise — the APY of their products.
What’s the difference between simple interest and compound interest?
An interest rate shows how much your money would grow over a specific period using simple interest. Simple interest does not include the effect of compounding.
Let’s say you deposit $10,000 in your bank account on January 1 and don’t touch it for the entire year. Your bank account has a 3% annual simple interest rate. This means they only pay interest once per year, at the end of the year. On December 31, your bank will add $300 to your balance for payment of the interest you earned.
Lucky for you, most banks don’t pay simple interest. Instead, most banks offer compound interest, which helps you earn more money. APY represents how much interest you’ll earn over the whole year after taking compounding into effect.
But what exactly is compound interest? It’s when you earn interest on money you put in the account and earn interest on the interest you’ve already earned. While this may sound complicated, it’s a good thing when it comes to building your savings in a bank account.
An example of compound interest shows why APY is important
Let’s take the same $10,000 deposited into a bank account on January 1. However, instead of simple interest, this time the bank offers a 3% interest rate that is compounded and paid monthly.
At the end of each month, the bank will deposit the interest you earn for that month into your account, rather than depositing interest just once at the end of the year. This means that on February 1, you’ll have your initial $10,000 plus the interest you earned in January ($25.48) in your account.
At the end of February, you’ll get another interest payment. But this time — assuming you didn’t withdraw any money from the account — you’ll earn interest on your initial balance ($10,000) plus the interest deposited at the end of January ($25.48).
So you’ll be earning interest on the interest you’ve already earned. This is what we mean by compounding. Over the course of the year, you’ll end up receiving $304.16 in interest rather than the $300 you’d earn with simple interest.
The $4.16 difference is why APY is important. If you simply compared two bank accounts that offer a 3% interest rate, you might think both offer the same earning potential for your money.
But once you examine how often interest compounds and use that information to calculate APY, you’ll realize the bank that compounds more frequently offers the best earning potential for your money as long as each bank’s interest rate is the same.
While compounding may not seem like a big deal over a few months, it can be a huge deal over longer time periods. Additionally, the more money you have, and the higher the interest rate, the bigger the difference that compounding interest will have over simple interest. That’s why banks use APY.
What is the difference between APY and annual percentage rate, or APR?
APY and APR are both ways to make apples-to-apples comparisons of different types of financial products. The major difference is that APY is used for deposit accounts, like checking accounts, savings accounts and certificates of deposit, figuring in compound interest on those accounts. APR, on the other hand, is used when you borrow money, and can include fees and other charges (on loans in particular) to show you the cost of borrowing.
Understanding how APY works is an important step toward understanding how your money grows.
Once you’ve made sure you’re receiving a decent APY, take time to learn how compound interest and returns work over longer time periods. If you can get started saving and investing early, you may be surprised how much compounding returns can help your money grow.