APY and Compounding
APY tells you how much money you actually earn in a year after compounding. If you are comparing savings accounts, APY is the number to trust.
APY in one sentence
The simple version:
APY (Annual Percentage Yield) is the yearly return you earn after compounding is included, assuming the rate stays the same.
Banks also advertise interest rates, but interest rate alone can be confusing because it does not always reflect how often interest is added to your balance. APY is meant to be a fair comparison number.
Interest rate vs APY
The basic rate used to calculate interest. On savings accounts, interest is usually added to your balance regularly, like monthly or daily.
The yearly result after compounding. It answers the real question: “If I leave my money here for a year, about how much will I earn?”
Teen friendly rule:
If you are comparing savings accounts, compare APY first. Then check fees and access rules.
What compounding actually means
Compounding is when interest earns interest. The bank adds interest to your balance, then next time, the interest is calculated using the new, slightly larger balance.
- Step 1: You deposit money.
- Step 2: Interest is added.
- Step 3: Your balance is now higher.
- Step 4: Next interest is based on that higher balance.
A useful way to think about it:
Simple interest grows like a straight line. Compounding grows like a curve. It starts slow, then becomes more noticeable over time.
How savings interest is paid
Many savings accounts calculate interest daily and pay it monthly. That wording matters: “calculate” is how they figure it out, “pay” is when it shows up in your account.
| Term | What it means | Why you care |
|---|---|---|
| Calculated daily | Interest is computed each day | Your balance each day matters; money added earlier earns a bit more. |
| Paid monthly | Interest is deposited once a month | You see interest show up on a schedule, not instantly. |
| Compounded monthly | Interest is added to balance monthly | Interest can start earning interest once it is added. |
In real life, the compounding frequency is usually not the biggest factor. The APY, your average balance, and how consistently you save matter far more.
What APY is good for, and what it is not
- Comparing savings accounts and money market accounts
- Understanding how much interest you might earn in a year
- Choosing a safe place to park cash short term
- Predicting investing returns (markets do not work like APY)
- Comparing loans (loans use APR, not APY)
- Assuming the rate will stay the same forever
Rates can change
Savings APYs can go up or down over time. APY is still the best comparison tool, just remember it is not locked unless the product specifically says it is.
Practical habits that make APY matter
Build a habit of saving regularly; consistency beats one big deposit once in a while
Avoid accounts with fees that can erase your earned interest
Keep an emergency buffer in cash, not invested; APY is for safe money
If you need the money soon, choose access and safety over chasing a slightly higher APY
Use APY to compare, then pick the account with the best mix of safety, access, and low friction
Key Takeaway
APY is the best number to compare for savings because it includes compounding. It tells you the real yearly earning power of your cash, assuming the rate stays the same, and you leave the money in the account.