What’s the difference for your savings?

When you’re shopping for an interest-bearing account, like a savings account or CD, you may have come across the term APY, or annual percentage yield. While the terms “interest rate” and “APY” have a lot in common, they measure how your money can grow in different ways. Understanding APY vs. interest rate will help you compare apples to apples when you’re shopping around for a new interest-bearing account. Here’s what you need to know.

Interest is the amount of money an account holder earns on a deposit. It can also refer to the amount lenders charge borrowers for taking out a loan. When a bank pays you interest on a deposit, like a savings account, it’s because you’re “lending” it money, and it’s paying you for the privilege. The interest you earn or pay is expressed as a percentage of an amount. 

Each financial institution offers different interest rates and pays them out (or charges them) at different intervals. Interest-bearing accounts at banks typically include savings accounts, CDs, money market accounts, and some checking accounts (though checking accounts tend to offer significantly lower rates than the others). 

On loans, the interest rate is either a flat rate (a fixed-rate loan) or fluctuates over the term of the loan (a variable rate loan). Each payment you make on the loan will include a portion of the principal, plus interest.

The two most common types of interest are simple and compound. If your bank pays simple interest, you earn money on the principal amount only. For example, if you deposit $5,000 and your interest rate is 3%, you’ll earn $150 every time the bank pays out interest. 

Compound interest factors in the interest you’ve already earned, and you earn interest on that amount too. Let’s say you now have $5,150 in your savings account after earning 3% in interest. The next time the bank pays interest, you’ll get $154.50 — that is, 3% of the full amount in the account. 

Depending on the financial institution, interest can compound at different frequencies. Typical compounding intervals, however, are daily, monthly, or yearly. 

Annual percentage yield, or APY, is the actual interest you earn over the course of a year, including compound interest. (Note that it’s not the same as an APR, which is the interest you pay to lenders.) It tends to be a more accurate snapshot of potential earnings over time. For example, an account may have an interest rate of 1.98%, but the APY — your actual rate of return — would be 2%, once you factor in compound interest. 

APYs can be variable or fixed. Most savings, checking, and money market accounts offer a variable APY, which means it can go up or down depending on what’s going on with the bank and the larger economy. CDs typically earn a fixed APY — that is, one that doesn’t change — for a specific period of time. 

To determine the APY, financial institutions calculate the interest rate and the number of compounding periods per year. The formula works as follows, with x representing the interest rate and y representing the number of compounding periods:

The more compounding periods per year, the more your money will grow. The difference may be small depending on how much money is in your account, but over time it can add up — especially with a high APY.

Interest rate is a percentage that represents how much interest you’ll earn on the original amount of money in your account. APY, also expressed as a percentage, is the total amount of interest you’ll earn over one year, taking into consideration compound interest. Many financial institutions show both the APY and interest rate, but it’s better to compare APYs when you’re deciding among accounts. 

When you’re comparing savings accounts, look at the APYs to see how much your money could grow over the course of a year. High-yield savings accounts, which tend to be offered by the best online banks, usually offer significantly higher APYs than savings accounts at traditional banks. The best savings account rates have topped 5% in recent months, more than eight times the average APY.

Aside from comparing APYs, consider these factors, too:

• Fees: Understand what monthly maintenance fees and overdraft fees the bank charges. Some financial institutions waive monthly fees if you meet minimum balance requirements. It’s becoming more common for banks to ditch overdraft fees, but in exchange they may deny your transaction. Think about other services you frequently use, such as wire transfers, and check how much the bank charges for those, too. 
• Customer service: Does the bank offer 24/7 customer service? Does it have a brick-and-mortar branch you can visit? How can you contact the bank — through secure messaging, on the phone, or via live chat?
• Access to cash: Look at the ways you can withdraw and deposit money. While most banks offer online and wire transfers, some financial institutions may give you an ATM card or the ability to conduct transactions in person. 

While some people use the terms interest rate and APY interchangeably, they actually mean different things. Ideally you want to find a bank that pays compound interest on deposits, since it will help your money grow that much faster. That means you’ll want to compare APYs rather than interest rates when shopping around. Since APYs are especially high right now, it’s the perfect time to see if your money is working as hard as it can in the bank.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at lauren.williamson@hearst.com.