An interest rate is the stated annual rate paid on a deposit. APY, or annual percentage yield, shows how much the deposit would earn in one year after compound interest is included.
For savings accounts, certificates of deposit (CDs), and other deposit accounts, APY is usually the better figure for comparing products because it accounts for both the interest rate and the compounding frequency.
APY vs. Interest Rate at a Glance
| Feature | Interest Rate | APY |
|---|---|---|
| Meaning | The stated annual rate paid on your balance | The annual amount earned after compounding |
| Includes compounding? | No | Yes |
| Best use | Understanding the base rate | Comparing savings accounts and CDs |
| Usually higher? | Not usually | Often, when interest compounds more than annually |
| Example | 5.00% interest rate | 5.13% APY with daily compounding |
Under the federal Truth in Savings rules, an account's interest rate does not reflect compounding. APY reflects the interest rate and the compounding frequency over a 365-day period.
What Is an Interest Rate?
An interest rate is the percentage a bank applies to your account balance to calculate interest.
For example, a savings account with a 5.00% interest rate has a base annual rate of 5%. The amount you earn can also depend on:
- How often the bank compounds interest
- When the bank credits interest to your account
- Your average or daily balance
- Whether the rate can change
The interest rate alone does not show the full effect of compounding.
What Is APY?
APY stands for annual percentage yield. It measures how much an account would earn in one year if the money stayed in the account and the stated terms did not change. APY includes compound interest.
Compound interest means you earn interest on both:
- Your original deposit
- Interest already added to the account
The basic APY formula is:
APY = (1 + r ÷ n) ^ n − 1
In this formula, r is the annual interest rate written as a decimal, and n is the number of compounding periods in one year.
Federal rules allow a bank to show the interest rate alongside APY, but APY must be clearly disclosed when an account advertises a rate of return.
Example: 5.00% Interest Rate vs. 5.13% APY
Suppose a savings account offers:
- Interest rate: 5.00%
- Compounding: Daily
- Starting balance: $10,000
With daily compounding, the APY is approximately 5.13%. If the balance stays unchanged for one year, the account would earn about $512.67 in interest before taxes, assuming the rate remains the same.
The APY is higher because each interest credit becomes part of the balance used to calculate future interest.
Which Number Should You Use When Comparing Savings Accounts?
Compare APYs when choosing between savings accounts, money market accounts, and CDs.
APY puts different compounding schedules on the same annual basis. For example:
| Account | Interest Rate | Compounding | APY |
|---|---|---|---|
| Account A | 5.00% | Annually | 5.00% |
| Account B | 5.00% | Monthly | Approximately 5.12% |
| Account C | 5.00% | Daily | Approximately 5.13% |
When two accounts have the same interest rate, the account that compounds more often generally has the higher APY. That figure is only one part of the decision, though. Fees, balance requirements, withdrawal restrictions, and promotional terms can affect which account works better for you.
What APY Does Not Tell You
APY does not show every cost or condition that can affect your return. Check these terms before opening an account:
- Monthly maintenance fees: These reduce the amount you keep.
- Minimum balance requirements: The advertised APY may apply only above a specified balance.
- Variable rates: The bank can change the interest rate and APY later.
- Promotional periods: A high APY may last only for a limited time.
- Withdrawals and deposits: The advertised APY generally assumes that the original balance and earned interest remain in the account for the full period.
- Taxes: APY is generally quoted before income taxes.
Federal deposit account disclosures include information about APY, interest rates, minimum balances, and fees.
APY Is Not the Same as APR
APY measures the return on money you deposit. APR, or annual percentage rate, is commonly used to measure the cost of borrowing.
For a loan, the interest rate is the cost of borrowing the principal. APR can include the interest rate plus certain fees and other loan charges.
Bottom Line
- Interest rate: The stated annual rate before compounding.
- APY: The effective annual return after compounding.
- Savings accounts: Compare APYs, then review fees, balance requirements, rate changes, and withdrawal rules.
- Loans: Compare APR and the interest rate because APR can include additional borrowing costs.