How Do I Understand APY?

By Indeed Editorial Team

Updated March 11, 2021 | Published February 4, 2020

Updated March 11, 2021

Published February 4, 2020

Building savings and contributing to an account regularly can help you feel more secure in case of emergencies or unexpected events. Regardless of the amount you save regularly, it's important to ensure that the funds you have are generating as much interest as possible.

Understanding interest rates and educating yourself on what banks offer can help you make the best decision for your needs. In this article, we explore what annual percentage yield (APY) is, how it works and review savings account tips to help you feel more confident when saving money.

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What is APY?

Annual percentage yield (APY) is the yearly rate of return on your deposit or savings account when considering compound interest. Compound interest is essentially interest earned on interest accumulated previously which is then added to the overall balance. As time passes, the overall amount in the account gets bigger and the interest earned increases as well. Compound interest is added periodically to the account, growing the amount and increasing the earning potential on the funds present. Higher APY means your balance grows faster.

How is APY different from interest?

An interest rate is the amount of interest that is paid on an investment or a deposit you make. The term, "simple interest," is applied when your funds earn the same amount of interest every year, calculated solely based on the amount of your initial deposit. Investing $1,000 at a five percent interest rate will result in your money earning $50 annually. Provided you don't add or take money out, your initial thousand dollar investment will continue to accumulate $50 each year.

APY calculates your balance taking into account compound interest, or the interest earned on the interest already earned. Leaving the interest in an account and allowing it to grow over time increases the balance more rapidly. With compound interest, the initial example of earning five percent interest on a $1,000 investment would see the balance grow more than $50 the second year because the balance base is at least $1,050 as opposed to the original $1,000. The earning potential increases because of the balance increase. APY is a more accurate estimation of the possible earnings and projected balance than simple interest.

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APY example

APY represents how much interest can be earned on a deposit over a year with compound interest. When searching for a savings account, APY can indicate which account will earn you the most interest.

For example: Imagine you have saved up $40,000 and deposit it into a savings account with 1.25 APY. After 12 months with interest compounded daily, your ending balance would be $40,503.13. After a second year, having not deposited or withdrawn funds, with interest compounded daily again, the ending balance would build to $41,012.59. The interest accumulates, is added to the overall balance and then works to accumulate more interest on the overall larger sum.

How APY and compound interest work

When money is deposited into a savings account, money market account, or certificate of deposit (CD) account, it earns interest. Interest is how much money a bank pays to keep your money on deposit or stored with them. Banks use the money you have on deposit with them to lend to borrowers who pay interest on those funds or loans, and the banks, in turn, pay you a percentage to keep you as a customer and to attract new ones. The interest rate varies from bank to bank, and sometimes from account to account based on the type of account you choose. The three most common types of savings accounts are:

1. Savings deposit account

These are also known as transactional savings accounts and are typically the easiest way to have your saved money earn interest. This account usually requires a small minimum deposit to open and if you maintain a specified balance you can avoid deposit fees.

They have high liquidity, which means that it is easy to withdraw funds if needed and they can be linked to a checking account or bank card to make transactions and transfers easier. They come with a maximum of six transactions per month. However, because of their ease and high liquidity, they often offer the lowest APY and interest rate.

3. Money market account

Money market accounts function on the same premise as transactional savings accounts. However, they usually require a higher initial deposit to open. Many charge fees if the deposit drops below a specified amount but these offer higher interest rates allowing your money opportunity to accumulate more interest.

These accounts also limit the number of transactions to six per month but do allow you to write checks for funds contained within the account. If a check is written for more than what the available balance is, the check will not clear. It will bounce.

3. Certificate of deposit account

Of these three most common savings accounts, certificates of deposit, or CDs, have the lowest liquidity (they are hardest to withdraw from) but have the highest APY. Saving money in a CD requires you to purchase one for a period of time ranging from a few months to ten years. This is called a "maturation period."

The longer the term the higher the interest offered. If you withdraw the money before the maturation period, you will likely be charged a penalty fee. However, leaving the money for the duration and then letting it roll over into a new CD will yield higher results as your balance will have accumulated interest and then the interest will be compounded in the new period.

For any of your savings accounts to yield the best results and benefit from APY, you will want to leave the earned interest within the account in addition to the initial deposit for the interest to compound. Additionally, you want to know how often a deposit compounds. The more often it compounds, the faster the balance increases.

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Savings account tips

When opening a savings account, you may want to consider the following:

The amount of initial deposit you are willing to make

Regular transactional savings accounts often only require a small deposit, with some banks only asking for a $20 initial deposit. If you are willing or able to deposit more, a money market account or CD may be more worthwhile as those two options will have a higher APY for your investment.

How frequently you will need access to the funds

The longer the funds remain in the savings account, the more interest accumulates. However, some accounts, like CDs, offer much higher APY because the intent is for the funds to remain for longer. If you need to access your funds more frequently, look for an account with higher liquidity.

How long you can leave the funds in the account

If you are considering a savings account for an emergency or maybe for future investment in education, you may want to look at options that have higher APY but require you to leave the funds for longer periods. CDs are good options in this case.

Higher APY

The higher the APY, the faster the balance builds. This allows for funds to build and when interest compounds your base balance will increase each year.

How often funds are compounded

The more often funds are compounded, the more your balance increases.

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