APY vs. interest rate: What’s the difference & why it matters

When it comes to interest-bearing accounts, you may come across the terms annual percentage yield, APY, and interest rate. But what is the difference between APY and interest rate, and are they the same thing? While the two are similar, understanding how they differ can help you have a better understanding of your expected returns or how much you owe.

While interest rates give you the percentage of the return you’ll earn (or pay) on your original balance, they have limitations, as they do not reflect compounding frequency or total return.

You will typically see interest rates on financial products, including:

• Loans: Where the borrower pays interest to the lender for a lump sum of money (includes mortgages, car, student, business, or personal loans).

• Credit cards: Interest is typically charged on credit card balances that are not paid in full by the due date.

• Bonds: Bonds are loans to a government or corporation, where interest is paid to the bondholder for “loaning” money.

• Savings accounts: Savings accounts often earn interest as compensation from the bank. Traditional savings accounts typically have modest interest rates, but options like high-yield savings accounts or money market accounts tend to offer more competitive rates.

• Certificates of deposit (CDs): CDs are time deposits where money is deposited for a set term and interest is earned at a fixed rate during the entire duration. CDs tend to offer the highest interest rates amongst savings accounts.

Compared to interest rates, APY provides a clear, standardized view of your true annual earnings potential, showing not just the rate you earn, but how often it helps your savings grow. Here’s a simple breakdown:

• APY includes compounding, so it gives a more accurate picture of your potential earnings than the basic interest rate.

• Higher compounding frequency (daily vs. monthly) can slightly increase your overall return. Daily compounding adds interest more frequently than monthly or quarterly compounding, allowing your balance to grow faster.

• APY assumes you keep your money in the account for a full year without adding or withdrawing funds.

Banks and credit unions often use APY to help consumers compare compound interest savings accounts, CDs, and other deposit products on an equal basis. Because APY accounts for compounding, it gives a standardized measure of real earning potential, unlike a simple interest rate, which doesn’t reflect how often interest is added to your balance. The more often interest compounds, the higher your effective return, even if the base interest rate stays the same.

This makes APY a transparent way to show how much your money could grow over time, regardless of differences in compounding schedules or term lengths.

So while APY and interest rates are often used together, they both represent different measures of earnings on a savings product. Here is a side-by-side comparison of APY vs. interest rates:

In essence, the interest rate tells you the nominal rate you’ll earn, while APY shows your actual yearly return once compounding is factored in, making APY a better measure for comparing deposit products like CDs and savings accounts.

Now that you have a better understanding of APY vs. interest rates, let’s take a look at an example of the two. Say you deposit $10,000 in a savings product advertising a 4% interest rate. Depending on how the interest is calculated (simple vs. compounded), your actual earnings may vary slightly.

Simple interest

If the bank uses simple interest (the 4% interest rate), it would calculate interest earnings only on your initial $10,000 deposit:

Simple interest formula: A = P(1 + r)

Where:

• A = total balance after one year

• P = principal (initial deposit)

• r = annual interest rate (decimal form)

Example: $10,000 x (1 + 0.04) = $10,400

Result: You would earn $400 in interest after one year.

This is a straightforward calculation with no interest-on-interest effects.

Monthly compounding

With compounding, the bank adds interest to your balance more than once per year (in this case, every month). Each month, you earn interest on both your original deposit and the interest you’ve already earned.

Compound interest formula: A = P(1 + r/n)^nt

Where:

• A = total balance after compounding

• P = principal (initial deposit)

• r = annual interest rate (decimal form)

• n = number of compounding periods per year (e.g., 12 for monthly)

• t = number of years

Example: $10,000 × (1 + 0.04 ÷ 12)¹² = $10,407.41

Result: You’d earn $407.41 in total interest after one year.

That’s $7.41 more than simple interest because your balance grows a little each month.

So, the APY is higher (4.074% vs. 4%) since it shows the real annual return once compounding is factored in. Even though the bank advertises 4%, your effective annual growth would be slightly higher due to monthly compounding. Banks and credit unions display APY because it gives a standardized way to compare products that compound differently (e.g., monthly, daily, or quarterly).

Understanding the differences between APY and interest rates can also help you make a more informed decision when it comes to saving and investing your money vs. borrowing. The distinction between APY vs. interest rate makes a big impact on the type of financial product involved and whether you’re a borrower or a saver/investor. Interest rates can help you understand the cost of borrowing, while APY can help you better estimate your total return on a savings or investment account.

Here’s a simple breakdown: 

For borrowers

Borrowers may want to focus on the interest rate (plus annual percentage rate (APR)) for the cost of borrowing. Borrowers may want to look at interest rates and APR when comparing:

• Mortgages

• Loans

• Credit cards

Interest rates can help you compare nominal rates, while APR gives a clearer picture of how much your debt will actually cost per year after fees.

For savers and investors 

Savers and investors may want to focus on APY to compare deposit products and to calculate how much your money can actually grow after compounding. This may be relevant when looking at:

• Savings accounts

• Certificates of deposit

• Money market accounts

• Bonds and other investments

APY can help you compare earnings across different institutions to help you choose a savings product to grow your money faster.

While APY and interest rates are closely related, understanding the difference between the two is important when making financial decisions. For savers, APY offers a more accurate view of how quickly your balance may grow in a deposit product like a CD or high-yield savings account. For borrowers, understanding the base interest rate (along with APR) can help reveal the true cost of loans or credit over time. Knowing which measure applies to your situation makes it easier to compare financial products on equal terms and align them with your goals.

If you’re looking to compare APY vs. interest rates on savings accounts, Raisin is here to help. The Raisin marketplace allows you to easily compare rates between account types, by displaying all of our partners’ account options with APY to enable easier comparison, and clicking on the “product terms” of each option reveals individual interest rates, to help you find a savings product that best suits your needs. Explore account types, compare rates, and sign up today to start maximizing your savings potential!

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.