APY vs. Interest Rate: How Compounding Changes What You Earn

Annual percentage yield (APY) and interest rate are often confused, but they measure different things. The interest rate is the base rate you earn, while APY includes the effects of compounding over a year. Because of that, APY is usually equal to or higher than the interest rate.

This guide explains how they compare and why the difference matters.

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Key Takeaways

• When comparing APY vs. interest rate, the interest rate is the starting point and APY tells the full story. The interest rate is the flat percentage you earn, while APY reflects what compounding adds over a year.

• APY is always equal to or higher than the interest rate. The more often interest compounds, the wider the gap between the two.

• Use APY to compare savings and interest rate to compare loans. Banks must disclose APY on deposit products, making it the fairer number for savings accounts, certificates of deposit (CDs) and money market accounts.

• Annual percentage rate (APR) is a third number, and it measures borrowing cost. APR includes the interest rate plus certain fees, so it's what you compare on loans and credit cards.

• A low rate can earn noticeably more with frequent compounding. For example, a 3% rate compounded monthly works out to a 3.04% APY.

Summary generated by AI, verified by MoneyLion editors

What's the Difference Between APY and Interest Rate?

Your interest rate is the base percentage a bank pays or charges on your balance. APY goes one step further by factoring in compounding, giving you a better picture of your total annual return.

Here's how the two compare:

• APY is always equal or higher than the interest rate. It will never be lower than the interest rate.

• A bank or financial institution is required to disclose APYs on its savings products.

• Compounding frequency matters. The more frequently interest compounds, the wider the gap between APYs and interest rates.

• Interest rates don’t typically include fees and compounding and so shouldn’t be used as a point of true comparison.

Why Is APY Higher Than the Interest Rate?

Compounding is the reason APY is usually higher than the interest rate. The interest rate is the base percentage applied to your balance, while APY factors in compound interest. The more frequently interest compounds, the larger the gap between the two. That’s the reason a compound interest savings account can grow faster over time.

• Yearly compounding: Interest is only compounded once a year so there’s no chance for the interest to compound on itself. There will be no gap between the interest rate and the APY.

• Quarterly compounding: There will be a slight gap since interest is compounded four times in a year.

• Monthly compounding: Compounding occurs 12 times in a year so the gap widens.

• Daily compounding: The gap is at its widest since the compounding occurs every day of the year.

How Do You Convert an Interest Rate to APY?

Converting an interest rate to APY requires factoring in how often interest compounds. If you know the interest rate and the compounding frequency, you can calculate APY using the formula below.

• APY = (1 + r/n)ⁿ – 1

• r = interest rate

• n = number of compounding periods — daily compounding interest would be 365

Quick Example

Imagine you have $5,000 in a CD account with a 3% interest rate. If it’s compounded monthly, the formula will look like this:

• APY = (1 + 0.03/12)¹² – 1 APY = 3.04%

To estimate your ending balance after one year, multiply your initial deposit by 1 + APY. In this example, your balance would grow to about $5,152 after one year.

Which Number Should You Compare When Shopping for an Account?

The number you should focus on depends on the type of account you're comparing. Use APY when comparing savings products and interest rate when reviewing loans or other lending products.

Review APY If You’re

• Comparing high-yield savings accounts, money market accounts or CDs

• Trying to estimate what you'll actually earn

• Deciding which account offers the better return

Review Interest Rate If You’re

• Comparing loan products

• Looking at the base rate before compounding is factored in

• Evaluating borrowing costs

Does This Work the Same for Savings, CDs, Loans and Credit Cards?

Although APY and interest are both expressed as percentages, they're used differently depending on the financial product. Here's what to look for.

Where Does APR Fit Into All This?

APR is the total annual cost of borrowing money. It's used for products such as personal loans, mortgages and credit cards, and includes the interest rate plus certain fees.

Unlike APY, which measures what you'll earn on savings and deposit accounts, APR measures what you'll pay to borrow money. While APY factors in compounding, APR is designed to help borrowers compare the overall cost of different loan products.

Bottom Line

• APY will be equal or higher than the interest rate.

• An interest rate is a base percentage, while an APY is what you’ll earn on a balance after compounding is taken into account.

• Always use APY to compare savings products like CDs and high-yield savings accounts.

• Loans and credit cards use APR to show interest rates.

• More frequent compounding raises your APY, so check how often an account compounds, not just its rate.

• Ready to put those comparisons to use? MoneyLion One can be a starting point.

FAQs

Why is my APY higher than my interest rate?

APY accounts for compounding interest. You earn interest on the principal and the interest rate you’ve already earned.

Is APY always higher than the interest rate?

APY is higher than the interest rate if compounding happens more than once a year. Compounding commonly occurs daily or monthly.

Should I compare savings accounts by APY or interest rate?

You should compare them by APY because it reflects annual earnings that factor in compounding.

If the interest rate is 5%, what is the APY?

The APY depends on how frequently compounding occurs. If compounding is daily, then the rate is 5.13% and if it’s monthly, the compounding rate is 5.12%.

What's the difference between APY, APR and interest rate?

• APY is how much you will earn on an account over the course of a year and includes compounding.

• APR is the amount you will pay over a year for borrowing funds.

• Interest rate is the base rate of cost or savings and doesn’t include fees or compounding.

Does a loan have an APY or an interest rate?

Loans use APR to account for the cost of a loan including fees.

Key Terms

• Interest rate: The base percentage a bank pays on your balance or charges on a loan, before compounding or fees are factored in. It's the starting point for calculating what you'll earn or owe.

• APY: The yearly return on a deposit account that includes the effect of compounding. It's equal to or higher than the interest rate and is the number to compare when shopping for savings products.

• Compounding: Earning interest on both your principal and the interest you've already earned. The more frequently it happens, the higher your APY.

• Compounding frequency: How often interest is calculated and added — daily, monthly, quarterly or yearly. Daily compounding produces the widest gap between rate and APY.

• APR: The yearly cost of borrowing, including the interest rate plus certain fees. It's used for loans and credit cards to compare total borrowing costs.

Summary generated by AI, verified by MoneyLion editors

Sources

• Consumer Financial Protection Bureau. 2024. "What is the difference between a loan interest rate and the APR?"

• Federal Deposit Insurance Corporation. "Consumer Assistance Topics."

• Consumer Financial Protection Bureau. "12 CFR Part 1030 - Truth in Savings (Regulation DD)."

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