Researching and comparing rates at financial institutions before borrowing money is a typical step when looking for a loan. You may be presented with interest rates and annual percentage rates (APRs) of current loan programs being offered by the institution.
On the other hand, when it comes to saving money, you might shop around for the best interest-bearing account. In that case, you’ll likely be given the interest rate for an account, along with the annual percentage yield (APY).
On the surface, it may not seem like there is much difference between APY and APR. But they are calculated differently.
With a loan, the interest rate is a percentage charged by a lender for the use of money, with calculations based upon the loan’s principal. In the context of a savings account, a financial institution agrees to pay you a certain amount of interest-based upon the money you have deposited in that institution.
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If you deposited money into an interest-bearing account, then you would earn an annual percentage yield on those dollars. The APY calculation takes into account the interest rate being offered, and then factors in any account fees and costs, as well as whether the financial institution offers simple interest or compounded interest—if the latter, then it also matters how often the financial institution compounds that interest—perhaps monthly or quarterly.
If the bank offers simple interest, then the interest is simply calculated on the principal balance. If, for example, you invested $10,000 at an interest rate of 1.5%, at the end of the year, you’d earn $150.
Compound interest, meanwhile, is interest calculated on the principal, plus any accrued interest—so, when compound interest is paid, it includes interest paid on interest.
Switching gears, when you borrow money from an institution and are quoted an annual percentage rate, this figure factors in the interest rate charged, along with fees and costs, but compounded interest is not part of the APR calculation.
One of the key differences in how APY and APR are calculated, then, is that one takes compounded interest into account, while the other one doesn’t.
The APY Formula
APY provides a picture of what you would earn on a deposit-based, interest-earning account over a period of one year.
The actual formula for APY calculation is as follows: (1 + r/n)ⁿ – 1.
The “r” stands for the interest rate being paid, while the “n” represents the number of compounding periods within a year. If, for example, the interest rate paid was 1.5%, then that’s what you’d use for the “r.” If interest is compounded quarterly, then “n” would equal four.
So, the frequency of interest compounding can cause savings accounts with the same interest rates to have different APYs. For example, if two different banks offered a CD with the same interest rates, and one of them compounded annually, that institution would have a lower APY than the institution that compounded quarterly, or daily.
The good news is that if you want to compare savings rates from one financial institution to another, you don’t need to perform these in-depth calculations. Financial institutions are required to provide information on APY as part of the Truth in Lending Act . And, here’s the heart of it all: the higher the APY, then the more quickly the money you deposit can grow.
Calculating interest on a loan is fairly straightforward, with the APR providing a better snapshot of the true cost of the loan to you on an annual basis. It may take into account the points you paid, for example, to get a mortgage loan, and/or other fees and loan-related costs.
Here’s where APR calculations differ from APY. APR does not take into account how often interest is compounded on a loan. And, the more often it’s compounded, the more you’ll ultimately payback on your loan.
So, in addition to comparing APRs at different institutions, asking how often interest compounding takes place on each loan could help inform your decision.
Here’s how an APR might be calculated: Fees and interest paid over the loan’s life would be divided by the original loan amount. Take that answer and then divide it by the number of days in the term of the loan. Multiply that number by 365, and then by 100. Ta-dah! That’s your APR.
While that’s the basic calculation, APR calculations can differ by loan type. Credit cards, for example, can have different APRs for purchases vs. for cash advances.
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Types of High Interest Accounts for Savings
When you’re saving money, there are several types of interest-bearing accounts that may be the right choice for your goals, with different APYs, fees, ready access to cash, and withdrawal terms.
Traditional checking and savings accounts don’t usually fit the bill when you’re looking for a high-yield account, although there are interest-bearing options that might fit your needs. Other choices can include money market accounts, certificates of deposits, and other forms of investments.
With a money market account, your money is typically invested in a relatively low-risk way, perhaps in government securities. If you don’t need regular access to this money, this could be a choice to consider, as there are often limits on how many withdrawals you can make monthly.
Generally, there is a $1,000 minimum to open a money market account and there may be incentives offered as investments reach higher amounts.
Certificates of deposits (CDs) are investments with fixed maturity dates, ranging from one month to 20 years—typically, you can’t easily withdraw money before that date. Some CDs are traded on the market as securities. Others are offered by banks, and aren’t securities. Interest rates tend to be higher on longer-termed CDs than ones with shorter terms.
Some CDs require a minimum deposit, while others don’t. Some CDs don’t charge penalties for early withdrawals, but many do, so read the fine print. A penalty can put a real dent in any interest earned.
If you want easy access to your CD dollars, you might seek out one with fewer withdrawal restrictions, or invest in CDs at regular intervals, helping to ensure that one will mature when you need funds.
Recommended: How Do You Calculate Interest on a Savings Account?
High Interest Checking Accounts
These are accounts designed to give you the flexibility of a traditional checking account, but with high-interest returns. Rates vary but are typically much higher than savings accounts. Many of these accounts, unfortunately, come with fine print, perhaps limitations on monthly debit card usage, or on minimum balances required, or mandated bill-pay automation.
What you really want to look for in the fine print, though, is whether or not there’s a balance cap on your interest earnings. This would basically limit how much money you can earn at the high-interest rate. For example, perhaps a bank would pay 3% on checking accounts, but you’d only earn that interest on the first $2,000.
In short, here’s the answer to “What is APY vs. APR?”:
• APY calculates money paid to you on depository bank accounts such as savings and certificates of deposit. It factors in the interest rate, plus any fees, costs, and compounding interest frequency.
• APR calculates the money you would owe to pay back loans, such as car loans and house mortgages. It factors in the interest rate, plus any fees and costs, but it does not take into account the impact of compounding interest.
When your goal is to maximize your dollars, one foundational step can be to maximize the interest you earn on savings.
One option to consider is a SoFi Checking and Savings® account where you can spend, save, and earn all in one place. We work hard to give you high interest and charge zero account fees. With that in mind, our interest rate and fee structure are subject to change at any time.
You’ll have the ability to write and deposit checks and you can use a debit card, send and receive money, and use ATMs, with the added benefit of earning interest.
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SoFi members with direct deposit can earn up to 3.75% annual percentage yield (APY) interest on Savings account balances (including Vaults) and up to 2.50% APY on Checking account balances. There is no minimum direct deposit amount required to qualify for these rates. Members without direct deposit will earn 1.20% APY on all account balances in Checking and Savings (including Vaults). Interest rates are variable and subject to change at any time. These rates are current as of 12/16/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
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