APY Vs. Interest Rate: Understanding the Differences
8 MIN READ
Published August 21, 2023 | Updated September 26, 2023
Whether you’re a borrower or an investor, knowing the difference between APY vs. interest rate can help you find the highest return on your savings and secure loans with the lowest interest rates. An interest rate is the amount you’ll earn on the original sum you invest.
Annual percentage yield (APY), is the total interest you’ll earn when you save or invest money, including the compound interest. The key difference here is compound interest. The higher your APY, the more you’ll earn in interest.
Read on to learn more about the differences between the two and how it impacts your financial decisions.
APY vs. Interest Rate on Savings Accounts
You may come across terms like annual percentage yield (APY) and interest rate when shopping for high-yield savings accounts. Many people use these terms interchangeably, but they mean completely different things, so let’s break them down further:
What Is Annual Percentage Yield vs. Interest Rate?
APY is the total interest you can earn in a year on money you deposit into an account. An interest rate represents the interest you earn only on the original deposit amount. APY and interest rates are both expressed as percentages.
The key difference between the two is the factor of compound interest. Interest rate only considers the interest you’ll earn on the original amount. APY takes into consideration the interest on the original amount and the compound interest you’ll earn in a year.
What Is Compound Interest?
Compound interest is the total amount of interest earned based on the sum of your original investment and all the interest you’ve earned from the account. Compound interest is desirable for investors because it can quickly grow the amount of money you make. With APY, you earn interest from your interest as your total grows or compounds.
Differences Between APY and Interest Rate
When comparing savings accounts, many individuals only compare the interest rate. Higher rates are usually considered better, but you won’t get an accurate picture just by looking at interest rates. You’ll also need to consider the frequency of compounding.
APY takes into account the interest rate as well as the rate at which interest compounds. Interest may compound daily, monthly, quarterly, or annually. The bank or financial institution will add the interest you earn to your balance.
With every compounding period, you’ll earn interest not only on the original amount you deposit but also on the interest you’ve earned. The interest rate compared to APY doesn’t consider this critical point, which is why it’s important to compare interest rate vs. APY on savings accounts.
Why Is APY Higher Than Interest Rates?
APY is higher than an interest rate because it also includes compound interest in addition to the original amount. Interest rate, on the other hand, only features the interest earned on the original amount, which is why it’s lower.
APY Vs. Interest Rate on CDs
Certificates of deposit (CDs) generally advertise their rate of returns based on APY and not the interest rate. CDs pay compound interest daily or monthly. Because of this, APY is a more useful measure of returns because it takes into consideration the impact of compound interest.
The APY on a CD is the amount of interest you’ll earn on it in a year. For example, if a CD pays 2% APY and you deposit $1,000 in it, you’ll have $1,020 at the end of the first year. When looking for a CD, look for an account that pays a higher APY for the desired investment term.
An important point to note here is that the actual APY you earn will depend on your withdrawals. If you withdraw or deposit dividends to a different account when you accrue them, you’ll lose the compounding benefits and the full APY.
APY vs. Annual Percentage Rate on Mortgages
When you borrow a mortgage, the annual percentage rate (APR) is the standard way of expressing the total cost of borrowing money. APY, on the other hand, is the interest you’ll earn on a deposit, investment, or savings account over a year.
APY does not apply to mortgages, so you can’t compare APY vs. APR on them. APR includes the interest rate and other fees associated with the mortgage loan, such as insurance premiums, closing costs, and origination fees.
APY comprises the interest rate and the frequency of compounding. Use APY to compare potential earnings and investment options. With APY, higher is always better.
Interest rate and APR together provide an accurate picture of how much your mortgage debt will cost you. You can use APR to compare mortgage products and choose the most affordable option. The idea here is to find a mortgage with the lowest possible APR. Remember, the higher your credit score, the more likely you'll find a lower APR.
Calculating APY and Interest Rate
There are several ways to calculate APY versus interest rate. You can use an online APY calculator that will allow you to input the interest rate and the compounding frequency to calculate the APY. If you know the interest rate and the APY, you can also calculate how much you’ll earn through simple interest and APY manually.
How to Calculate Annual Interest Rate and APY
Let’s look at some examples of how interest rates and APY are calculated and how these calculations impact your money:
If you deposit $10,000 in an account that earns a 5% annual rate, you’ll earn $500 in interest at the end of a year. Your total balance at the end of the first year will be $10,500.
Let’s say you deposit $10,000 in a savings account that pays 5% APY with monthly compounding frequency. To calculate how much you’ll earn in interest, divide 5% by 12 (0.00416). Next, multiply that by your principal amount, which is $10,000. This means you’ll earn $41.6 in interest after the first month.
The next month, your principal balance will be $10,041.6, so you’ll multiply the monthly interest (0.00416) with your new balance of $10,041.6. With this calculation, you’ll earn about $41.77 in interest at the end of the second month. At the end of the year, you’ll earn about $500 in interest.
Comparing the Two
Financial institutions and banks show their rates as APY, but they can also highlight the corresponding interest rate. When choosing a savings account, CD, or other investment product, it’s important to know the APY. Knowing the rate that includes the compounding frequency will provide you with accurate information about how much you’ll earn in a year.
Teresa Dodson, debt expert and founder of Greenbacks Consulting LLC, advises, “regardless of which type of interest you go with, make it a priority to understand the rate and if it’s the very best you can do.”
For example, if you’re comparing high-yield savings accounts, you need to know the frequency of compounding and when your bank account is credited. Compare the APY offered by one bank to the APY offered by other banks. Make sure to check that compounding rates are equivalent to get an accurate picture. Comparing the interest rate offered by one account against the APY of another account isn’t effective because they’re completely different measures.
The Bottom Line on APY Vs. Interest Rate
APY and interest rate are both critical components of personal finance and money management. Be mindful of quoted rates when shopping for a credit card, auto loan, home loan, savings account, or CD. Always read the fine print to ensure you understand which rate is quoted before you compare APR vs. APY vs. interest rate.