Annual percentage yield (APY) explained
The APY on your savings account will determine how much extra money you earn every year while your money sits in your account. In other words, the higher your accounts APY, the more money you will make on your savings.
APY should not be confused with APR. You may have seen the acronym APR referenced on credit card agreements, loans, and mortgage rates. APR stands for annual percentage rate, and unlike APY, it does not include the effects of compounding interest.
Compound interest is a powerful financial principle that essentially means getting paid interest on your interest. Compounding interest takes effect once you receive your first interest payment.
For example, let’s say you had an investment that paid you $5 in interest on your $100 principal, meaning you now have $105. If the interest compounds, it means the next interest payment you receive will be paid based on $105, which includes the last interest payment. If the interest wasn’t compounded, your next interest payment would still only be for the original $100 principal and not include the $5 of interest.
Compound interest is what makes APY so powerful. The longer your money compounds and earns interest, the larger it grows.
Annual percentage yield (APY) example
Let’s say you deposit $1,000 into a high-yield savings account that pays you a 1% APY on your savings. After one year, your $1,000 would have increased to about $1,010.04. If you kept that balance in your savings account, the following year, it would increase to $1,020.18. If the interest didn’t compound, after the first year, your balance would be $1,010.00 instead of $1,010.04.
Although the amount of extra interest you earn seems insignificant, it adds up exponentially with larger balances and longer periods.
It’s also important to note that some banks pay out interest at different frequencies, so compounding effects will be different depending on the payout frequency. For instance, a bank can payout interest daily, monthly, quarterly, semi-annually, or annually. Most banks will payout quarterly, but the frequency varies.
It’s worth mentioning that the frequency of interest payouts doesn’t have a significant impact on how much your savings earn over time. For example, $1,000 kept in a 1% APY savings account that paid interest quarterly for four years would be worth $1,040.76. If that same account paid interest daily for four years, your end balance would be $1,040.81, a $0.05 difference.