When I went online to check on the new CD I just opened, I noticed something interesting. The bank listed the Annual Percentage Yield (APY) as 1.50%. But the Interest Rate (APR) says 1.49%. So why is my APY higher than the interest rate?
The simple answer is that it’s a math thing. And the power of compounding. But I realized some of you might want to understand more about that. Is the bank sneaking .01% for themselves to pay for wild parties? No. Let me explain.
How an interest rate works
Let’s say you deposit $1000 in your bank savings account. And the interest rate is 5% (I wish). If your interest is calculated at the end of the year, you get a simple $50 interest credited to your account at that time.
But if your bank compounds your interest monthly or even daily, then you will be earning interest on your original amount. PLUS you’ll earn interest on your interest. A very nice thing indeed.
In the $1000 deposit example, the 5% interest rate (APR) becomes a 5.13% annual percentage yield (APY) if compounded daily. And you wind up with $51.27 at the end of the year. That’s an extra $1.27 through compounding.
And in my case, with an APY higher than the interest rate because my bank compounds daily, the simple bank interest rate is 1.49%. But I get an effective rate of 1.5% after one year. Not as exciting as 5%, but it adds up — and is far better than .01% my regular bank pays for savings.
A bit of bank marketing magic
Before you get too excited about daily compounding, notice whether your bank uses APY or APR in its ads. I signed up based on the APY number. And it was a good one for my needs. Something I always look for since I know that’s the net amount I get at the end of the year.
But as I looked at my APY vs APR numbers today, I thought about what an average investor might be thinking. When you hear that you get DAILY compounding, and a 5% yield (again not in this market) you might think “Wuhoo! I’m making even more.”
You’re not. And that’s ok. As long as you know to always look for the Annual Percentage Yield (APY) number. That’s what you’ll really earn. And it should always be higher than the stated interest rate. Or the same if the stingy bank compounds annually.
Where else banks use a little slight of hand
With an APY higher than the interest rate, banks often choose to feature one over the other in their ads. Depending on the product. The Street points this out quite nicely:
“… For this reason, banks generally list the APR for debt-related accounts such as credit cards and mortgages, whereas APY often appears next to interest-bearing accounts such as certificates of deposit (CDs) and money market accounts.”
As long as their wording is careful, there’s nothing illegal about this. Just a little slippery for consumers who don’t read the fine print. But knowledge is power. And now you know!
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