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How Important Is APY for a Savings Account?
Even at a time when many Americans are simultaneously not saving money and saving more money than ever, savings accounts remain a valuable place to safely store your money. With FDIC insurance, your balance isn’t at risk, and you can withdraw it as needed.
The drawback, however, is the relatively low interest rates as the Federal Reserve cut rates in March 2020 in response to the COVID-19 pandemic.
Most people know that when a bank offers you an APY on a savings account, it’s talking about interest rates. In general, the higher the interest rate, the better. However, APY is subtly different from the interest rates you may be familiar with, and that difference can cost you if you’re not aware of it.
Let’s take a closer look at what exactly APY is, how it affects your savings account, and what that means for you in terms of depositing and withdrawing money.
What is APY?
APY is short for annual percentage yield, and it describes the percentage of your balance you would earn if you left the money sitting in that account for a full year, untouched. This includes any interest earned later in the year on interest accumulated earlier in the year.
APR, on the other hand, is short for annual percentage rate, and that’s the actual annual interest rate offered on your savings account. It does not include any interest earned later in the year on interest accumulated earlier in the year.
Knowing the difference is critical, and it’s all about understanding compounding.
Different savings accounts pay out interest at different times throughout the year. Some pay out interest once per quarter, while others do it once per month.
When interest is paid out, the bank calculates the average balance of your account during that time span, then uses that number to determine how much interest to pay you. It uses a fraction of your APR that matches the fraction of the year that it’s paying out for.
APR and APY would be exactly the same if banks paid out interest once a year, but when they pay it out more frequently, the interest you earn in, say, the first quarter begins to earn interest itself in later quarters.
So, let’s say that your bank pays out a 1.2% APR on your savings account, but they compound monthly. That means that each month, it pays out 1.2%/12, or 0.1% of your average balance for the month. If that average balance is $10,000, it pays you $10.
The next step is where APR and APY begin to diverge. The next month, if you left the account alone, you have an average balance of $10,010 in there. Again, the bank pays out 0.1% of your average balance, but that now means you accumulate $10.01 in interest — 0.1% of $10,010. Now, your balance is $10,020.01. The next month, the bank pays $10.02 in interest, changing your balance to $10,030.03. This keeps repeating until you wind up with a balance, at the end of the year, of $10,120.66.
For this account, which offers a 1.2% APR and compounds monthly, you would be quoted the APY instead, and that’s 1.2066% (likely rounded to 1.21%). In other words, the APY is just a bit higher than the APR, and the difference gets bigger when the APR is higher and when interest is paid out more frequently (monthly is better than quarterly, for example, and produces a bigger gap between APY and APR).
The important thing to remember is that to get the full APY savings, you have to leave your money there untouched for the full year. If you pulled your money out after two months, with a balance of $10,020.01, your annual rate of return on that money would only be 1.2006%, not the 1.21% you’d get over the course of a full year. You only get the full APY value if you leave your money alone for a full year.
Why is APY so important?
There are two big reasons why it’s so important to understand APY.
First, APY indicates what your annual rate of return would be if you left the money alone for a full year. You only get your full APY if you leave the money completely alone — interest included — for a full calendar year. You can withdraw it earlier, but your rate of return on that money will be lower because you didn’t allow for the time needed for your interest earnings to fully grow. This tends to be a small difference when interest rates are as low as they are now, but it can make a big difference in times with higher interest rates.
Even with that catch, APY is the preferred number banks like to quote you because it’s a little higher than APR and thus looks better. In other words, APY is the number you should use to compare the interest rates on various savings accounts, and it’s the most important number if you’re simply using a savings account to hold a lump of cash for a while until you need to withdraw it.
Where can I get the best APY?
Let’s take a snapshot look at the current APY offerings from several of our top savings account picks. In general, the best savings account rates are found with online banks, so it’s worthwhile to know the basics of online banking before choosing one.
*Rates accurate as of December 7, 2020.
If your goal with a savings account is to simply deposit a sum of money, let it sit until you need it, then withdraw it, with minimal transactions or other needs, then APY is the most important factor in a savings account.
If you’re looking for a more full-featured bank, want a checking account and strong customer service features, APY becomes a less essential factor, particularly when interest rates are low. This is because banks change their interest rates somewhat regularly, and because the amount you’ll earn is usually relatively small compared to other banking fees and potential inconveniences due to poor customer service.
For a good all-around bank with strong interest rates, I recommend Ally Bank. Its mix of great customer service, strong online banking tools, and a wide ATM network make it a great choice as a primary bank, and its interest rates are competitive, too.
Re-evaluating your banking options is a great end-of-the-year financial task, even if you decide to stick with your current bank.
It’s also worth asking if putting money in a savings account is the best option, particularly while interest rates are low. Savings accounts are perfect vehicles for emergency funds, but you may want to consider other financial options if you have a large windfall on your hands. Consider paying down debt instead of saving or investing for retirement.