Last Updated: October 12, 2021
The world of finance is laden with confusing and overwhelming terminology. The annual percentage yield (APY) and interest rates are two such terms that may perplex us. This article addresses the APY vs interest rate comparison, helping you to understand what both are and how they work.
What Is APY?
The annual percentage yield (APY) is the yearly rate of return on money in a bank account. The more explicit APY definition explains that APY represents the real rate of return earned on a savings deposit or an investment. The APY accounts for compound interest—interest on both the total amount of money you have in your account and on the interest that accumulates over time.
The majority of savings accounts and certain checking accounts have an APY. This type of interest can also appear on loans or credit cards, and, as such, you’ll need to pay compound interest on your debt. The higher the APY, the higher the return.
|NOTE: An APY increases if it has more frequent compounding periods. Find out how often your money compounds—daily and quarterly compounding is better than annual compounding.|
How Does APY Work?
An APY works like an interest rate. But unlike regular interest rates, an APY periodically calculates compounding interest, meaning that the longer you have money in your bank account, the greater the return. This greater return is based on periodic growth—money grows as time goes by.
What Does APY Mean in a Savings Account?
If you deposit $100.00 in a savings account, with an annual APY of 5%, at the end of the year, you would have $105.00 in your account. But if the frequency of compounding interest is calculated quarterly, the principal sum (plus the amount of interest) would come to $105.09. Although this might not seem much of a return, with larger sums, you can receive substantial returns. And as the interest grows year-after-year (or quarter-after-quarter), so will your earnings.
|NOTE: Interest-bearing accounts, such as savings accounts, can have both interest rates and APYs—although the rate of return on the two might be significantly different.|
What Is Interest Rate?
An interest rate is the percentage of the principal sum that you receive as compensation for the money you place in a deposit account—or the percentage that you need to pay to the lender when taking out a loan. More precisely, the interest rate definition constitutes a proportion of the amount lent, deposited, or borrowed—depending on how much money you borrow (or save) and the interest rates for said money, as well as the length of time over which the money is deposited or borrowed.
Interest percentages can be quite different, depending on whether you’re borrowing or saving. If you’re saving, you are technically lending money to the bank. In return, you get interest rates deposited to your account at typically not much more than 0.5%. But if you’re taking out a loan, you can expect to pay up to 15% of the principal sum in interest rates.
What Is an APR?
The annual percentage rate (APR) is an annual rate of interest that is slightly different from the simple interest rate. It’s usually applied on different loan types but most commonly on consumer loans. The most typical example of this type of interest is with credit accounts, with the APR being the annual amount of interest that you need to pay to the lender. The APR is usually higher than the interest rate, but lender fees and closing costs can sometimes be calculated in this payment. The APR outlines the key difference between the annual interest rate and APY—you need to pay the APR, and then the APY pays you.
Types of Interest Rates
There are three types of interest rates: mortgage interest, credit card interest, and payday loan interest.
A mortgage is one of the biggest loans available for consumers, as well as one of the most significant transactions you’ll ever handle. The interest rate can be 3 to 18%. You need to decide if you’re willing to pay the fixed rate before committing to a mortgage.
There is one major difference with the mortgage interest rate vs APY determination: the functional fixedness of the rates. Mortgage rates are usually fixed and do not grow periodically, while the APY rates are variable, providing additional interest.
Credit Card Interest
Credit card loans are riskier in comparison to home loans, auto loans, and other auto financing offers since there is no collateral for the credit card issuers to collect in case of missed payments. This is the reason why credit cards have the highest interest rates (14 to 24% for different types of credit offers). And you must be careful when applying for more than one credit card because this could get you stuck in debt.
Payday Loan Interest
These are short-term loans that provide small sums of money taken out of the applicant’s next paycheck at a high interest rate. Because these are quickly approved, they need to be quickly repaid. Lenders, then, charge high-interest rates to make a profit in a short amount of time.
|NOTE: The mortgage interest rate in 2021 stands around 4%—the lowest it’s ever been in US history, as opposed to the rate 40 years ago. In 1981 the mortgage rate was 18.5%.|
|APY: the actual rate of return you’ll earn with compounded interest.|
|Interest rate: the fixed rate of return you receive on savings accounts.|
|APY vs interest rate: both earn you money on interest-based accounts.|
|Interest rates are more common and offer lower returns than an APY.|
|The higher the APY, the better.|
|NOTE: APYs are advertised for those who want to save—banks want to attract people’s investments by offering a higher percentage yield.|
APY vs Interest Rate
The main difference between APY and interest rate is the compounding interest. An APR or simple interest is usually distinguished in the context of borrowed money, while the APY is more commonly associated with the interest you gain when you invest money. Simple interest rates can be applied to both borrowing and investing money. An APY earned vs interest rate earned on a savings account is typically significantly higher.
|NOTE: Roth IRA accounts deliver annual interest returns between 7 and 10%. If you’re unfamiliar with these accounts, you can read what a Roth IRA is here.|
APY and Interest Rate on Savings Account
A savings account APY vs interest rate: the two can significantly differ. Earnings from an APY interest will slowly increase, while the interest rate is fixed. And the return you get will stay the same, year after year.
The interest rate vs APY savings difference will be evident at least after one compounding period has passed, and then the measure of the interest received can be compared. Concerning loans and rates, an APY is a much worse option for you.
|NOTE: The variable interest rate definition describes an ‘adjustable’ or ‘floating’ rate that changes over time because it’s based on a periodically changing index or an underlying benchmark interest rate.|
Interest Rate Lower Than APY?
The battle of interest rate vs APY is a long-standing one, with interest rates offered more often than APYs. But APYs are more attractive to customers. Interest rates are offered for many different types of accounts—banks avoid paying large amounts of money to their clients based only on a certificate of deposit for an insubstantial amount of money. APYs are more lucrative—banks incentivize you to invest your money with them by offering a higher, escalating return.
|NOTE: A savings account does not only keep your money safe, but it can also help you earn a substantial amount each year. When considering opening a savings account, check out the great IRA saving accounts.|
APYs or Interest Rates for Savings?
An APY provides the most accurate sense of what you’ll earn in a year. If possible, get both. But when deciding about APY vs interest rate savings, the best course is to go for the APY that offers the higher rate. In this way, you’ll see your savings accumulate. It helps if the APY rates are adjusted daily or at least on a quarterly level since in one year, you can observe not only your savings increase but your return increase, as well.
|NOTE: Certificates of deposits (CDs) are investments with fixed maturity dates, ranging from one month to 20 years. And you can’t easily withdraw money from this investment account before the maturity date has passed. When mulling over the APY vs interest rate CD decision, you’ll realize that you can get a higher return on longer-term CDs.|
Convert APY to Interest Rate?
An APY can be converted to an interest rate. But how often is the compounding interest calculated for the APY account? The difference between the interest rate vs APY savings account and the different types of transactions should be made clear by your bank or the organization where you’ve decided to invest your money. Note six steps of the conversion process:
- The conversion process begins with converting the APY rate into a decimal number. This is done by dividing the APY percentage by 100; so, if your APY is 5.5%, you’ll get the decimal 0.055.
- Add 1 to the decimal number—continuing with our example, this would be 1.055.
- The number you get in step two (1.055) has to be raised to the 1/nth power. Here, N equals the number of times per year interest is compounded—so if your account compounds interest monthly, you would raise 1.055 to the 1/12 power and get 1.004471699.
- Subtract 1 from 1.004471699, and you get 0.004471699.
- The number from the fourth step (0.004471699) needs to be multiplied by the times per year the interest is compounded, e.g., 0.004471699 x 12 = 0.053660387.
- When calculating the interest rate vs APY, you need to multiply by 100 and get to a percentage to find the interest rate. If you multiply 0.053660387 by 100, you find the interest rate equals 5.366% (if the APY is 5.5 %, and interest is compounded monthly).
|NOTE: If you have a savings account and you want to know what’s the difference between your annual interest rate vs APY, you can use a savings calculator to find out what kind of return you’ll get with both of these options.|
The principal difference of APY vs interest rate is in the additional interest the APY accrues over time. If we compare rates of return, the APY has a higher return and is a more attractive option for those who want to save because it compounds interest. An APY is typically the smarter way to go.
In most cases, the interest rate will be provided by the organization you’re investing with. They can calculate exactly how much return you’ll receive. If this is not the case, you can use an interest rate calculator to determine what your returns will be.
An APY can be calculated using a simple formula: APY = (1 + r/n )n – 1, where ‘r is the stated annual interest rate and ‘n’ is the number of compounding periods each year. All you need to calculate the APY is to know the interest rate and compounding frequency…and a calculator.
In the world of decentralized finance (DeFi), cryptocurrencies can earn a return. Users can put cryptocurrencies in a digital deposit account, where they are entitled to receive an APY. Some accounts offer additional subsidies on top of this in the form of a new token, much like the APY vs interest rate structure.
The effective interest rate is the real return you receive from a savings account or another interest-paying investment, with the effects of compounding over time calculated into the return. It also reveals the real amount of debt owed on a credit card, mortgage, or loan.