How does APY work?
To enable customers to make informed decisions, banks are required to display the rates they offer on accounts prominently. With simple interest, you only earn a fixed rate throughout. Simple interest of 2.5% on a principal amount of $5,000 is $125. The amount is added once and that’s it.
The great thing about APY, though, is that interest is compounded, i.e., interest earnings are added periodically.
Say you start with a principal of $25,000 in a savings account with a 3.0% APY, if interests are added monthly, $62.50 will be added to your account after the first month. For the second month, interest earned will no longer be calculated based on the original $25,000.
Instead, your balance grows to $25,062.5 ($25,000 + the $62.50 earned) and you earn interest on your new balance. This continues for as long as you let it. At this rate, at the end of the 12th month, your balance would have grown to $25,760.
Financial institutions may compound interests daily, monthly, quarterly or yearly. The shorter the compounding duration, the better. Interests compounded daily is the best; yearly, not so good.
The Effect of Compounding on APY
As shown above, annual percentage yield of 3.0% on $25,000 will return a profit of $760 after the first year. Given how much was invested, the accumulated interest may seem small. However, the effect of compounding on percentage yield needs some time to kick in and earning good returns on a deposit account is a long-term strategy. If the $25,000 is allowed to continue growing, by the fifth year, the balance would have risen to $29,040. That’s an easy $4,000 just for keeping your money in the bank.
After the tenth year, the account would have grown to $33,733; allowing the owner to take profits of over $8,700. That translates to an increase of almost 35% on the original amount. The APY may have been 3%, but due to the effect of compounding, the account holder enjoyed a 10-year increase of 35%.
After 15 years, the principal would have grown by over 56%.
Why is APY important?
Everyone needs to set some money apart for emergencies and future needs. The smart thing is to let your rainy day fund earn APY until the time you’ll need it. With a high enough APY and a short compounding period, you can grow your balance significantly within 5 years.
When shopping for savings accounts, money market accounts or CDs, every percentage increase in APY counts. If the $25,000 above was not invested, after 10 years, the amount remains the same. If inflation is factored in, the owner ends up losing value on the money.
If kept in a savings account with an APY of 2.0%, however, the balance after 10 years is $30,529. Compare this to the $33,733 balance accumulated on the 3.0% APY account. Due to a 1% reduction in APY, profits reduced by over $3,200. With more principal or a longer term, the difference becomes more pronounced.
While the interest rates on deposit accounts may be small, the compounding effect of APY makes them a worthwhile investment option.
How to Find Savings Accounts with High APY
According to the FDIC, the national average APY for savings accounts is 0.09%, and the average APY for 1-year CDs is 0.66%. These are very low, and while some banks offer rates that are significantly higher than these, some other banks have lower APYs. Here are some tips to help you find good value in deposit accounts:
- The biggest banks typically have lower APYs than online banks, credit unions or community banks. For example, Chase offers an APY of 0.01% on savings accounts; significantly lower than the national average. Capital One offers 1% APY, which is quite competitive for a national bank. Online banks have the highest APYs, though. By avoiding the operating costs that come with physical branches, some online banks are able to offer customers annual percentage yields as high as 2.5%.
- Ironically, people avoid online banks for the same reason their rates are higher because they have no physical branches. However, as long as you choose a bank that’s insured by the FDIC, you’re covered for up to $250,000 of your savings - this figure is the same for all FDIC-insured financial institutions. Additionally, some online banks offer round-the-clock customer support, so customers can reach bank representatives whenever they need to.
- CDs generally have higher APYs than savings accounts. The catch is that your money is invested for a pre-agreed duration and if you withdraw it earlier than stipulated, penalties will be charged on your account. Opt for CDs with high APYs and low-penalties.
- Money market accounts also have higher interest rates than savings accounts and you can withdraw your funds at any time without penalty. However, these accounts usually have a minimum balance requirement, and you may need a sizable principal to qualify.
Remember that for APYs, every percentage point counts. Also, the more your principal is, the shorter the compounding period, and the longer you keep your money in a deposit account, the higher the returns.
And finally, if you need the money within a short period, a savings account is your best bet. If you’re certain that you can do without the funds for some years, take advantage of the great annual percentage yields that long-term CDs offer. Money market accounts allow you to enjoy the best of both, as long as you don’t mind their restrictions. Some financial institutions offer high-yield reward checking accounts but their restrictions are even stricter than those of money market accounts.
