You might see the terms "interest rate" and "annual percentage yield" (APY) used interchangeably when talking about interest-bearing accounts like HYSAs and CDs.
The two are related — and both are expressed as percentages — but there are important distinctions.
The difference between APY and interest rate
An interest rate accounts only for simple interest on the principal, while an APY also factors in compound interest. The APY tells you the actual percentage you'll earn, assuming you didn't touch the money. Simple interest is often used to calculate loans, but is less common with savings products.
If you deposited $1,000 in an account earning 5% simple interest, you'd earn $50 after a year and have a total of $1,050.
For an account earning compound interest, the formula is different.
- Divide 5% (or 0.05) by 12. Then, multiply that figure (approximately 0.00416) by $1,000 to get 4.17. So, after one month, you'd earn $4.17 in interest on that initial $1,000 deposit. You would therefore start the next month with $1,004.17.
- For the second month, multiply $1,004.17 by 0.00416 to get to 4.18, or about $4.18 in interest. After two months, your total balance would be $1,008.35.
- If you didn't deposit or withdraw any money, your balance at the end of 12 months would be $1,051.16.
Financial institutions tend to advertise APYs over interest rates when promoting savings accounts to help customers understand how much they'll earn over time.
Both HYSAs and CDs typically pay compound interest, but the rate on a HYSA fluctuates, while CD rates are typically fixed.
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FAQ
What's the difference between an interest rate and an APY?
An interest rate accounts only for simple interest on the principal, while an APY also factors in compound interest. It depends on both the interest rate and the compound frequency.
Why is an interest rate lower than an APY?
The simple interest rate is lower because the APY accounts for compounding, or interest earned on previously earned interest. For comparing interest-bearing accounts like CDs and HYSAs, it's a more accurate measurement.
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