What is an APY and How Does it Work?

You’ve probably seen or heard the abbreviation APY when looking at a savings or checking account, money market account, certificate of deposit, or other types of earning accounts, but what is it, and how does it work?

APY is the abbreviation for “Annual Percentage Yield.” Now that we know what APY stands for, let’s dig into what it means and how it works.

The APY lets you know what kind of return to expect.

APY stands for Annual Percentage YIELD. So, think of it as what you will earn or yield, taking into account compound interest. In other words, these types of accounts will have an APY advertised with them, but you must also consider how often that yield is compounded to calculate your return. There are two types of interest you’ll encounter: simple and compound. 

With simple interest, you earn the exact advertised return rate on the original deposit you put into the account (assuming you leave your funds alone for 1 year). For example, if you put $1,000 in an account earning simple interest at a 3% rate of return on January 1, you will end that year with $1,030 exactly ($1,000 x 3% = $30).

With compound interest, though, money is earned on the principal balance AND on the interest you have already earned. Think of it as “interest on interest.” Compounding occurs in a set period, usually monthly or quarterly. The more frequently your rate is compounded, the more you’ll earn. Using the example above, let’s see how this looks compounded monthly and quarterly. 

When compounded quarterly, an initial deposit of $1,000 with a 3% APY, will yield $1,030.34 at the end of the year since you earn interest on your interest each quarter (every three months) with an initial deposit of $1,000. 

When compounded monthly, an initial deposit of $1,000 with a 3% APY, will yield $1,030.42 at the end of a year since you earn interest on your interest each month, plus your initial $1,000.

See? Just take your initial deposit amount, factor in the APY and rate of compounding interest, and you can calculate how much interest that money will make in a year. This doesn’t include any taxes or fees, though, so be careful to research if there are any fees associated with the type of account you’re placing your money into. But generally, the higher the APY, the more return you gain from your initial deposit. 

Types of APY Accounts

When you’re deciding where to put your money for safekeeping, there are various types of accounts to choose from. Typically, people look for the following types of APY accounts: savings, money markets, and certificates of deposits (CDs). However, sometimes you can find other types of deposit accounts with an APY, such as Arkansas Federal’s Elite or Premium Checking, but there are requirements to be met, such as making a certain number of transactions each month and maintaining a specified minimum balance.  

All of these accounts—savings, money markets, and certificates of deposit—will come with a certain APY that is typically based on the account balance but sometimes have other requirements that must be met. Let’s explore each to find the best account for you.  

With a regular savings account, sometimes called a “share savings” account at a credit union, your financial institution may require a minimum opening deposit and may also require a minimum balance to avoid monthly fees. However, these types of accounts typically don’t offer very high APYs since they are generally flexible accounts with low balance requirements. If you’re just starting your savings journey or tend to keep a low balance, this could be a good choice for you, though. 

Another option is a money market savings account. These types of accounts will have a bit higher APY than a regular savings account, but you will probably be required to keep a higher minimum balance to get the return and avoid monthly maintenance fees. Also, many money market accounts come with tiered APY rates meaning that you get a higher return when you have a higher balance.  

A certificate of deposit is another account with an APY, but unlike a savings or money market account, you will be required to keep your money in the account for a certain amount of time or face an early withdrawal penalty. Typically, a certificate of deposit will give you a better APY than a regular savings or money market account, but again, you must leave your money in there for a certain amount of time, called a term, or pay an early withdrawal penalty. The term can be as little as a few months to years and the length of the term will be tied to a specific APY. If you anticipate not needing your funds soon, this is a great option to maximize your return.  

Regardless of which account you choose, make sure it’s with either an FDIC or NCUA financial institution. That way, your funds will be insured up to $250,000 in case of a bank or credit union failure.

APY May Vary

Before committing to one of these accounts, you will also need to check to see if the APY is variable or fixed. When an APY is listed as variable, it means that it can fluctuate and change with market interest rates. So, when the Federal Reserve raises or lowers its target interest rate, variable APY rates typically follow. A variable APY is usually attached to regular savings, money markets, and high-yield checking accounts.  

However, with a certificate of deposit, your APY rate is typically fixed, meaning that it won’t change over the term (length of time) you and your financial institution have agreed to. So, there’s no need to worry about market fluctuations.

APY vs. APR

APR and APY may sound and look similar, but they are different, so it’s important that you don’t get confused by the two.  

Unlike APY that tells you how much you will earn or yield on your funds, APR represents the cost of borrowing money annually and stands for Annual Percentage Rate. APR applies to products such as credit cards, personal loans, car loans, and more. In short, APR refers to the interest rate you may owe the lender over one year. 

Generally, you want as high an APY you can get when it comes to earning on your money and want as low an APR you can get when you want to borrow. The higher the APY, the more you earn on your funds. The lower the APR, the less you pay in interest to borrow funds.

Bottom Line

When it’s all said and done, APY can help you save more effectively. When you understand APY, it’s a valuable tool for evaluating the best place to keep your money when you’re looking to save. Ready to get started? At Arkansas Federal, we have several accounts with competitive yields, or APYs. Whether you’re looking for a simple savings account, a money market, or a certificate, we can help you find the best account to help you reach your goals.