Just the other day, when we asked some people around the office how they’d describe “APY” to a friend, we heard all sorts of different answers. So we got to thinking… let’s define some of these tricky terms for people in a way that actually makes sense, complete with examples and some visuals. Because hey, we all learn a little differently.
When you deposit money into a bank or credit union, you’re essentially loaning it to them. The bank will actually invest your money and use it for other sorts of transactions, so to say “thank you” banks will pay you interest for keeping your money in the account. So when you check your balance, the money looks to be right there but really, it’s hard at work doing other things behind the scenes.
There are two kinds of interest you could be earning on your account: simple and compounding. With simple interest, you’re earning money just on your principal balance. You calculate it by multiplying your principal balance times the interest rate.
For example let’s say you have $5,000 as your principal balance in your account and your interest rate is 2%. Over the course of a year, your account will earn $5,000 x 2% = $100 in interest, for a total of $5,100 in your account. The next year you’ll earn $100 again, and so on.
Compounding interest is a little different. We’ll tell you why and how.
With compounding interest, you’re earning interest on your entire account balance. That means if you’ve already earned interest on money in that account, you will earn interest on both the principal balance* and previously-earned interest.
Let’s take the same example from above. You’re earning 2% interest compounded monthly on a principal balance of $5,000. The formula here is a little more complicated but what it means is that at the end of the year you would have $5,100.93 instead of $5,100. Even though for now it’s a difference of just under $1, as the account balance grows, so does the overall interest you’re earning.
Over a longer period of time, compounding interest has a big impact. Over 10 years, you’d earn $1,106.02 instead of $1,000, and over 30 years, you’d earn $4,106.04 in interest instead of just $3,000.
A compounding schedule is super important too. The example above was compounded monthly. The more often it’s compounded, the more money you’re potentially earning. So if you’re looking at rates, check to see how often the interest is actually being calculated. Daily, monthly, and yearly can actually make a pretty big difference over time. (Just as a heads up, your Protected Goals Account is compounded and credited monthly.)
Ok, so now that we’ve talked about interest and power of compounding, let’s dive into APY. The acronym stands for Annual Percentage Yield and it’s basically the total amount your account will grow within a year (including compounding interest) expressed as a percentage.
Rates vary from one financial institution to the next, and a lot of factors go into determining the rate. Some include: risk, financial standing of the institution, market competition, overall market conditions, and the federal interest rates.
When you’re shopping around for the best rate, make sure to compare APYs rather than the interest rate. APY is the only reliable number that allows shoppers to compare rates because by law, it has to be calculated the same way across the industry. Choosing to go with an account with the highest APY will ensure you’re getting the most bang for your buck.
APY came about after a bunch of financial institutions were offering high interest rates to customers, and then quickly lowering them again. It became clear that banks were abusing the way rates were advertised and it was confusing consumers. In 1991, regulators demanded that financial institutions disclose the truth about rates and fees, and thus, the Truth In Savings Act was born.
APY was introduced so customers could have faith in the system, and shop around to get a better sense of what their money could actually earn.
What’s a Good APY?
The higher the number, the better. But make sure to notice if there’s a minimum balance required to earn the rate. Some banks have super high deposit requirements before you start earning the great APY they advertise. For example, if you need to deposit $5,000 to earn the 1.50% rate, you will not be earning that 1.50% APY unless you have (and keep!) at least $5,000 in that account. Also, there may be balance caps, so your high-yield interest is only good for money up to a certain balance, then you might earn a lower interest rate for balances above that threshold.
A Few Other Helpful Terms Defined
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