Key takeaways

• APY reflects annual earnings by factoring in compound interest, not just the stated interest rate.
• Comparing APYs can help evaluate savings accounts, CDs, money market accounts, and other interest-bearing deposits.
• APY is one factor to consider alongside account fees, balance requirements, and access to funds.

When comparing accounts with compounding returns, such as high-yield savings accounts and certificates of deposit (CDs), it’s important to know the annual percentage yield, or APY.

APY is a percentage value that represents the total amount of interest you can earn on certain accounts during the year. It uses compounding interest and bases its value on the stated interest rates and the number of compounding periods during the year, such as daily or monthly. The earned interest goes toward your account balance and helps it grow faster.

Comparing APY rates instead of solely interest rates can help you better understand how much you can expect to earn over a 365-day period. Here’s a closer look at APY rates and how they can impact your personal finances.

What is APY?

APY stands for annual percentage yield. It is the annual rate that shows how much interest an account can earn in a year when compounding is included. APY is commonly used for savings accounts, CDs, money market accounts, interest-bearing checking accounts, and some cash management accounts.

APY can provide a more complete picture of an account’s earning potential than the nominal interest rate alone. Since APY accounts for the effects of compounding, it can show more accurate comparisons between interest-bearing accounts.

How APY works with compound interest

APY is closely tied to compound interest — which is earned on both your original deposit and the interest already credited to your account. As your balance grows, future interest is calculated on a larger amount, potentially helping your savings grow faster over time. 

The frequency of compounding can also affect earnings. Depending on the account, interest may compound annually, monthly, daily, or another schedule. In general, the more often interest compounds, the more interest you can earn over time. 

Accounts with the same stated interest rate can have different APYs if they compound at different frequencies. Here's how a $10,000 deposit might grow over one year with a 3.00% stated interest rate, but different compounding frequency:

The Truth in Savings Act requires financial institutions to round the APY two decimal points in displays so you can easily compare rates. For account disclosures, the interest rate may be expressed in more than two decimal places.¹

Read more: Understanding compound interest and its power

How is APY calculated?

If you want to calculate APY, it’s ideal to get familiar with several key factors:

• i: interest rate on account
• n: number of compounding periods in a year
• d: initial deposit

With this information, you can use the annual percentage yield formula below to determine the APY percentage.

[(1 + (i / n))n – 1] * 100 = APY

For example, let’s say you’re opening a high-yield savings account. The interest rate is 3%, and it compounds monthly. The APY rate is 3.04%.

((1 +(0.03 / 12)) ˆ12 – 1] * 100 = 3.04%

You can then use this figure to determine how much you can earn during the year. For instance, if you deposit $10,000 into this savings account, you can expect to earn $304 in interest in a year for a total balance of $10,304.

You can also save yourself this step by using an online annual percentage yield calculator. Financial calculators like this can help you make informed decisions.

APY vs other measures of interest rates

APY is not the only method for measuring interest. Other methods include nominal interest rates and annual percentage rates (APRs). The major difference between APY and these other methods for measuring interest is that APY uses compounding rates, and the other methods do not.

Below are more details about other ways to measure interest rates.  

Nominal interest rates

Nominal interest rates are one of the easiest methods to understand and calculate. It measures the basic interest rate before compounding.

You can multiply your deposit by the listed interest rate to calculate the interest earned. Using the example above, you can calculate interest earned using the nominal interest method by multiplying the $10,000 initial deposit by 3%, for a total of $300 (10,000*0.03). 

The $4 difference between using the nominal interest rate ($10,300) over APY with compounding ($10,304) may not seem like a lot, but over time, it can make a significant difference in how fast you can grow your wealth.

APR vs APY

As mentioned above, the major difference between APR and APY is that APR doesn’t use compounding interest. This is because APR is typically associated with loans (mortgages, auto loans and personal loans) and credit cards. Lenders often use APR to determine the amount of interest you owe during the course of the year, rather than how much interest you earn.

Read more: APR vs APY: What’s the difference?

Where APY shows up

APY is primarily used for interest-earning deposit accounts, where it shows how much you can earn in a year after compounding. Common products that advertise an APY include:

High-yield savings accounts 

Traditional savings accounts 

Certificates of deposit (CDs) 

Money market accounts 

Interest-bearing checking accounts 

Cash management accounts (offered by some brokerage firms and fintech companies) 

How to compare APYs before choosing an account

The Truth in Savings Act requires banks, credit unions and other financial institutions to provide detailed information prior to consumers opening an account. This makes comparing options more transparent and easier to understand.²

When stacking up your options, your first choice may be to invest in accounts that offer the highest APY with the hopes of achieving the highest return. However, much can depend on whether the offered APY is fixed, variable, tiered, or promotional. 

A fixed APY remains the same for a specified period. It is commonly associated with certificates of deposit (CDs), where the APY is locked in for the length of the term. This provides predictable earnings because the rate does not change during the agreed-upon period.

A variable APY can increase or decrease over time. It is common with high-yield savings accounts, money market accounts, and interest-bearing checking accounts. Financial institutions may adjust the APY in response to changes in market interest rates or other economic factors.

Tiered APYs may pay different rates depending on your account balance, while promotional APYs are often available only for a limited time or under specific conditions.

It is also important to review whether and account has minimum opening deposit or ongoing minimum balance requirements. Some accounts require you to deposit or maintain a certain balance to qualify for the advertised APY. If your balance falls below the required threshold, you may earn a lower rate.

You can also check whether the account has balance caps pertaining to APY. For example, an account may pay its top advertised APY only on the first $10,000 or $25,000 in the account, while any amount above that earns a lower rate.

Read more: CD vs. HYSA: Key differences and when to use each

APY and your cash plan

Considering a short list of factors besides APY can help lead you to the correct option for your situation. Much can depend on the intended use of the savings and how often you might need access.

• Financial goals: Before choosing a yielding account, it’s important to set clear goals and objectives. For example, are you saving for the long-term or planning for something in the medium or shorter-term like purchasing a home? Perhaps your setting aside money in an emergency fund intended to cover financial surprises — like an unexpected car repair bill — or maybe you’re starting a sinking fund that typically covers planned but irregular expenses, like vacations. 
• Access to cash: If you want an account that gives you immediate access to your money, a high-yield cash account may be a potential solution. On the other hand, if you’re OK setting aside a specific amount of money for a set period, then a CD may be a potential option for you.
• Additional fees: Don’t forget to read the fine print. Accounts and products can come with annual fees or service charges. Be sure to take these additional fees into consideration when comparing options.

Read more: What is a sinking fund? 

The bottom line 

Understanding APY makes it easier to compare the earning potential of savings accounts, CDs, and other interest-bearing deposit products. However, APY is only one part of the decision. Be sure to also consider your financial goals and specific situation.