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Interest Rate vs. APY: What's the Difference?

When you’re researching and planning to open a savings account, you’ll often see two numbers listed: the interest rate and the annual percentage yield — abbreviated as APY. In the world of finance, they are often used interchangeably, but what exactly do they mean? And what’s the real difference between the two?

The interest rate is the percentage of your original deposit that the bank will pay you each year, expressed as a simple percentage. It’s essentially a “reward” for lending your money to the bank.

The APY, on the other hand, reflects more accurately how much money you’ll earn from your savings in a year and is more important to know when choosing a savings account. It takes into account compounding, which happens when your money grows as interest is added. Over time, interest is earned on the original balance as well as the additional interest added to the account (compounded). The APY represents the amount of interest you’ll earn in a year when compounding is factored in. This effect leads to greater returns, especially over longer periods.

Say, for example, that you have a savings account with a 5.00% APY¹ — if you have $10,000 in that account, you'll earn $500 in interest in one year. The bank will pay you interest on your initial deposit, as well as interest on the interest you continually earn. Different financial institutions compound at a different frequency, whether daily, weekly, monthly or annually. In real life, Bask Bank^® offers the benefit of compounding daily, which may translate to a higher APY than you’d see at banks compounding less frequently, and in turn a higher account balance at the end of a year.

To be specific, for your hypothetical account with $10,000 that compounds daily, your account will accrue interest each day, and the next day you’ll earn interest on the new amount on top of how much you had before. Each day you’ll have more money in your account, and it’ll compound exponentially. A theoretical 5.00% APY translates to a 4.88% interest rate, and the interest in a period is calculated by: account balance × rate × number of days ÷ 365 — so $10,000 × 0.0488 × (1/365) = $1.34 interest accrued the first day. With the $1.34 in interest, your new balance the next day will be $10,001.34. Then, you’ll accrue interest on the new amount, and the pattern will continue for 365 days. In a shorter month, like February, you’ll earn less interest because there are slightly fewer days. Daily Interest accrued is typically credited to your account at the end of each month.

APYs are always equal to or higher than interest rates. When you’re comparing savings accounts, be sure to look at the APY rather than the base interest rate to get a better idea of how much money you’ll actually earn on your savings, because APY provides a more accurate measure of your return on investment. The APY is typically advertised by financial institutions more visibly, but interest rates may not always be as prominently displayed.

Here are a few tips for choosing a high-yield savings account with a competitive APY:
 

• Make sure the account is FDIC-insured, which means your money is insured to at least $250,000 per depositor for each account ownership category. For joint accounts, each co-owner is insured to at least $250,000 for the sum of their interests in the account, and adding beneficiaries may further increase the amount of insurance coverage. For more information regarding insurance coverage, the FDIC provides a Deposit Insurance Summary Guide, Your Insured Deposits Guide, and the Electronic Deposit Insurance Estimator (EDIE). 

Understanding the difference between interest rate and APY is essential for making savvy financial decisions that can set you up for future success. By following these tips, you can find a savings account that will help you maximize your money over time.