Opening a savings account is one of the best choices for putting funds aside and growing your money. It comes with many advantages —it’s low-risk, easy to set up, and offers high interest rates.
However, before choosing and opening a savings account, you need to make sure you’re getting the best deal. This is where you have to look out for the APY—the higher it is, the more money you’ll make.
But what is APY on your savings account, and why do you need to learn about it? In this article, we’ll answer all your APY-related questions and show you why it matters in your savings account selection.
What Is APY on a Savings Account?
Annual percentage yield (APY) represents the interest you’ll earn on the funds you deposit and keep in your savings account over a year. It’s always shown as a percentage.
APY acts as a standard metric for the rate of return on your investment, and it helps you choose the most lucrative savings account.
Types of APY
There are two types of APY:
- Variable—It fluctuates based on market conditions and can potentially offer higher returns but with less predictability. It’s common in savings and checking accounts as well as money market accounts (MMAs)
- Fixed—It remains constant throughout the year, which makes it stable and low-risk. Bank accounts usually feature it as a promotional offer
While you may think one type of APY may be better than the other, there’s no clear winner between the two. For example, a fixed APY might seem attractive because of its stability, but it could also lead to missed opportunities if the Federal Reserve raises rates.
How Does APY Work on a Savings Account?
APY calculates the total amount of interest earned on the funds in your savings account over one year. It takes into account your interest rate and compounding frequency, which refers to how many times the earned interest is paid out during the year.
The more frequently interest is compounded, the higher the APY, and the faster your savings grow. Here are the compounding frequency options:
- Daily compounding
- Monthly compounding
- Yearly compounding
Daily Compounding
With daily compounding, your interest is compounded and added to your balance every day. For example, if you have $1,000 in your savings account with a 0.5% annual interest rate compounded daily, here’s what to expect:
- On day one, you’ll earn $0.01369 in interest (the daily interest rate will be 0.5 divided by 365). Your balance will be $1,000 + $0.01369 = $1,000.01369
- On day two, you’ll earn interest on your new balance ($1,000.01369). This means at the end of day two, your balance will be $1,000.01369 + $0.01370019 = $1000.02739019
This process will continue every day for the rest of the year.
Monthly Compounding
This type of compounding means that interest is added to your account every month. For example, let’s say you invest $2,000 at an annual interest rate of 6% compounded monthly.
- After one month, you earn one month’s interest at 0.5% (6% divided by 12), making your investment worth $2,010
- In the second month, you earn another month’s interest at 0.5%, but this time, it applies to both your initial investment and the $10 interest you earned last month. This means your investment grows to $2,020.50
Yearly Compounding
With yearly compounding, your interest is added to your account once every year. For example, let’s say you add $5,000 to a savings account with an annual interest rate of 0.6% compounded yearly.
- In year one, you’ll earn $30, making your new balance $5,030 at the end of the year
- The next year, you’ll earn $30.18, bringing your balance to $5,060.18
This process will continue annually, with interest being added to your balance at the end of each year.
How To Calculate APY on a Savings Account
The APY formula is as follows:
APY = (1 + r/n)^n – 1
Where:
- r = interest rate
- n = number of annual compounding periods (365 for daily, 12 for monthly, or four for quarterly)
To help you better understand the formula, take a look at a step-by-step example of how it’s used in the table below. In our example, we’ll use an annual interest rate of 6% and monthly compounding.
| Step | Description | Example |
| 1 | Add the periodic rate and the number of compounding periods into the equation | (1 + 0.06 ÷ 12)^12 – 1 |
| 2 | Solve the calculation within the parentheses | (1.005)^12 – 1 |
| 3 | Raise the result in the parentheses to the power of 12 | 1.061678 – 1 |
| 4 | Deduct 1 from the result to obtain your APY | 0.061678 |
| 5 | Multiply your APY by 100 to turn it into a percentage | 0.061678 x 100 = 6.1678% |
| 6 | Multiply the APY by the initial deposit amount. This gives the total interest earned over a year | $2,000 x 6.1678% = $123.356 |
| 7 | Add the interest earned to the initial deposit. This gives the total balance in the account after one year | $2,000 + $123.356 = $2,123.356 |
APY vs. APR—What Is the Difference?
APY and APR are both expressed as percentages and are often confused with one another. Still, they’re not the same—the annual percentage rate (APR) represents the annual interest rate paid to a bank or lender on a loan, while APY is the interest you earn on a deposit.
You’ll commonly find APY as a feature on savings accounts, certificates of deposit (CDs), and money market accounts, while APR relates to credit cards, loans, and loan refinancing.
What Can Affect APY?
The factors that affect APYs on savings accounts include:
- Federal Reserve interest rates
- Market conditions
- Compounding frequency
Federal Reserve Interest Rates
Your savings account APY can be influenced by changes in the federal rate. If the Federal Reserve decides to increase interest rates, your account’s APY might see an uptick. However, if the rates are lowered, your account’s APY could experience a decrease.
The Federal Reserve can adjust rates for various purposes, such as to stimulate economic activity or encourage borrowing and investing.
Market Conditions
APYs are closely tied to the economy. When the economic conditions are stable, financial institutions offer higher APYs to encourage people to save and make investments.
However, during economic downturns or periods of uncertainty, institutions usually offer lower APYs to reduce risk.
Compounding Frequency
With a high compounding frequency—such as daily or monthly—the accumulated interest is added to the principal more often. This leads to a higher overall return.
In contrast, less frequent compounding, such as annual compounding, means that interest is added less frequently, lowering the APY.
How To Make the Most of Savings Accounts
Since your APY shows what you earn on the money you save in your account, the higher it is, the more you’ll earn. For this reason, you need to look for the highest APYs possible to make sure you’re choosing the best savings account option. To do that, try the following:
- Open a high-yield savings account
- Leave your money in for as long as possible
- Maximize account security
Open a High-Yield Savings Account
If you want a high APY and low fees, you should open a high-yield savings account. While they come with certain cons, high-yield savings accounts offer the highest APYs available. They also provide easy access to your funds through online and mobile banking platforms so your money isn’t stuck, and you can withdraw it at any time.
High-yield savings accounts are offered by:
- Online banks
- Credit unions
- Brick-and-mortar banks
Leave Your Money in for as Long as Possible
Take advantage of compound interest by leaving your money in the account for as long as possible. This allows it to grow over time.
For example, if you put $10,000 into a savings account at 1.5% APY that’s compounded monthly, your investment could exceed $12,000 after five years.
Maximize Account Security
Banks offering traditional savings accounts are primarily concerned with providing fast and easy payments, while the security aspect relies on FDIC insurance. A common misconception about this insurance is that it protects savings from fraud, while in reality, it only provides security in case of bank failure.
Enter FortKnox by Austin Capital Bank—a security-oriented banking platform that helps you earn interest on your savings while protecting your funds from scammers. With a sole focus on fraud prevention, FortKnox offers safe storage of cash reserves in high-yield savings accounts.
