With interest rates on savings accounts and bank CDs at long term lows, it’s important for savers to make sure they’re getting as much as possible on their accounts. But it can be difficult to figure out which account pays the highest effective rate, since there are different ways to compound interest, as well as different deposit terms for things like bank CDs. This is why it’s important to know the “Annual Percentage Yield” (or “APY”) for each type of account.
What is APY? Annual Percentage Yield is a way of calculating a standardized rate that enables savers to compare the interest generating aspects of different savings accounts and products.
Here are some of the nuances of APY:
Different Methods of Interest Compounding Yield Different APYs. For example, a one year $10,000 bank CD that pays simple interest at an annual rate of 2% will yield $200 in interest at the end of the year. But a one year $10,000 bank CD that pays interest at an annual rate of 2%, compounded monthly, will yield $201.84 in interest at the end of the year. Even though both CDs have an interest rate of 2%, the first has an APY of 2.00% while the second has an APY of 2.02%.
Required Standard APY Disclosures. The Truth in Savings Act administered by the FDIC mandates that all banking institutions provide an Annual Percentage Yield disclosure to prospective savers for each of its savings products. This APY disclosure is presented in terms of the amount of interest that the saver would earn on a $100 deposit over the course of one year. This disclosure makes it easy for individuals to compare different products, without having to perform any compound interest calculations yourself.
The Stated APY Won’t Include Fees and Charges. Even though the purpose of a standardized annual percentage yield is to provide a comprehensive measure of the interest that a saver will receive, it’s important to note that the APY does not account for fees or other charges that would effectively reduce the interest you receive. Be on the watch for fees such as those that may apply if you choose to receive paper statements, and any fees tied to making too many transactions in any particular month for passbook and similar savings accounts.
The Stated APY Won’t Account for Early Withdrawal Penalties. Furthermore, particularly in the case of certificates of deposit or other time-deposit accounts, if you withdraw or close your account early then you may forfeit a portion of interest that you’ve already earned. Obviously this will reduce your effective APY, but an added variable is the fact that different banks may impose different levels of interest forfeiture or comparable products.
Just as knowledge and self-education is essential to making the right decisions when it comes to taking out a new loan, it’s also important when you’re trying to decide where to save your money. Compare the annual percentage yields of the various savings products you’re considering so that you can earn the greatest possible return.
With interest rates on savings accounts and bank CDs at long term lows, it’s important for savers to make sure they’re getting as much as possible on their accounts. But it can be difficult to figure out which account pays the highest effective rate, since there are different ways to compound interest, as well as different deposit terms for things like bank CDs. This is why it’s important to know the “Annual Percentage Yield” (or “APY”) for each type of account.