APY Shows What Compounding Adds to a Deposit Rate
Five percent, said the banner ad — yet the year-end statement shows slightly more than that actually arrived. Compounding did the extra work, and APY is the number that saw it coming.
APY, or annual percentage yield, states what a deposit earns in a year with compounding included. It exists so accounts that compound on different schedules can be compared with one number.
The compounding math
Put $10,000 in a savings account paying a 5% nominal rate, compounded monthly. Each month's interest starts earning interest of its own, and the year ends near $10,511.62 — an APY of about 5.12%.
The same 5% compounded just once at year-end would finish at $10,500. The gap looks small over one year, but it's precisely the gap APY measures — and compound interest widens it every year the money stays put.
Daily compounding at that same 5% nudges the APY a touch higher still, to about 5.13%. More frequent compounding always helps, but each step up matters less than the last.
Comparing accounts
Two accounts can quote the same rate and pay different amounts because one compounds daily and the other monthly. APY settles the contest: higher APY, more interest, whatever the schedule.
That's why banks must disclose APY on deposit products. When you shop for a savings account or a CD, compare APYs, not nominal rates.
What APY can't promise
Most savings APYs are variable, so the advertised number can drop after you open the account. A teaser rate can fade to something ordinary within months.
Fees and withdrawals bite too. A monthly maintenance charge can erase the interest on a small balance, and money pulled out mid-year never earns its share.
APY vs. APR
APY measures what deposits earn; APR measures what borrowing costs, and only APY bakes compounding in. Same letters, opposite directions — check which one a quote is using before comparing anything.
For official guidance on deposit accounts, see the FDIC's deposit-account guidance.
Check your account's APY against what banks are advertising this month — if it's badly beaten, moving the balance takes minutes.