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What Is APY?
What Is Interest Rate?
What Is the Relationship Between Interest Rate and APY?
Interest rate is a component of APY.
Heres an example to make the difference clear.
Imagine you put $1,000 into a savings account that pays an interest rate of 5%.
However, if you reinvest that interest payment, your balance will steadily increase.
For example, imagine in the above example you reinvest your interest payment every month.
After the first month, your account balance will be $1,004.17.
If you had not reinvested your interest, you would have only received $50 in annual interest payments.
But by reinvesting, you earned an extra dollar.
This extra dollar represents your APY.
While your interest rate was a flat 5%, your APY on that account was actually 5.1%.
Which One Is More Important to Investors?
As most investors reinvest the income they receive in their savings accounts, APY is generally more relevant.
How To Calculate APY
Calculating APY involves using a standard mathematical formula.
For example, suppose you have $5,000 in aCD accountwith a 5% interest rate.
In this case, your final account balance would be$5,255.81, when account balances are compounded monthly.
The difference is particularly striking the longer that you remain invested, and the higher return you earn.
This would give you a total account value of $50,000 after the 40-year period.
Melanie Grafilcontributed to the reporting of this article.
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