Whether shopping around for a new loan, applying for a credit card, or determining when your savings will reach your goal, it’s important to understand the difference between APY and interest rate. While both can provide valuable insight into the loans and savings accounts you’re considering, APY takes into account compounding to give you a more complete picture of what you earn or owe. Ultimately, the difference between APY and interest rate comes down to what type of return you want on your investments. APY expresses the amount of money you will earn on your deposit, while interest rates express the percentage of return on the principal invested.
APY and interest rate are common terms you’ll hear when discussing savings accounts, certificates of deposit (also known as CDs), and other investment vehicles. However, they are not the same, and understanding their distinction can help you make smarter decisions about where to save and invest your money. It will also ensure that you get the most out of your investments by taking into account how compounding works. You can also use this information when calculating your tax liability, as the IRS considers any interest earned to be taxable income.
Another factor to keep in mind is that some savings accounts pay a higher APY than others because they require consumers to sacrifice immediate access to their money. For example, CDs often require that consumers leave their money untouched for a certain period of time, called a term. This typically ranges from three months to five years, and if the consumer wants to withdraw their funds, they’ll likely be subject to an early withdrawal penalty. As such, these types of accounts typically offer the highest APY. Understanding how these differences work can help you plan your finances and save with confidence.
Example
To illustrate the difference between interest rate and APY, consider a savings account with a 5% interest rate that compounds monthly. If you only look at the interest rate, you might think you’ll earn 5% per year. However, the APY will be slightly higher than 5% because of monthly compounding. This is because each month, you earn a little bit of interest on the interest earned in previous months.
In summary, interest rate is a simple percentage that does not account for compounding, while APY is a more accurate measure that considers compounding, making it a better tool for comparing the actual returns or costs associated with different financial products. When evaluating savings or investment opportunities, paying attention to the APY is important to get a true sense of the potential growth or cost over time.