How APY Works, and Why Two Accounts at the Same Rate Pay Differently
Compounding frequency, balance tiers and introductory periods all sit behind one advertised number.
Annual percentage yield is the figure banks advertise on savings accounts, and it exists so that accounts can be compared. It folds compounding into a single number, which makes it more useful than the stated interest rate.
APY and interest rate are different
The interest rate is the base figure. APY reflects that rate plus the effect of compounding over a year.
An account paying 4.00% compounded monthly produces an APY slightly above 4.00%, because each month's interest earns interest for the remaining months. Compounded daily, it edges higher again. The gap is small at ordinary rates and grows with the rate.
When you compare accounts, compare APY against APY. Comparing one bank's rate against another's APY is comparing two different measurements.
Where the advertised number stops applying
Balance tiers. Some accounts pay a headline APY only up to a cap, then far less above it. Others invert this and pay the top rate only above a minimum you might not hold. Read the tier table rather than the banner.
Introductory periods. A promotional APY for the first few months reverts to the standard rate afterwards. Note the reversion date when you open the account.
Activity requirements. High-yield checking accounts frequently require a set number of card transactions, a direct deposit, or enrolment in paperless statements each cycle. Miss the requirement and the rate drops to a token figure for that month.
Variable rates. Savings account rates are almost always variable. Your bank can change the rate at any time, and rates across the market move with Federal Reserve policy. The APY you opened with is not a commitment.
Check your rate twice a year
Banks routinely leave existing customers on older, lower rates while advertising better ones to new customers. Comparing your current APY against what your own bank advertises today takes two minutes and often finds a gap.
Where the yield comes from
A bank pays you for deposits because it lends them out at a higher rate. The spread between what it pays depositors and what it charges borrowers funds the business.
This explains a persistent pattern. Online banks without branch networks carry lower costs and consistently pay more than large branch-based banks. The difference is often several percentage points, which on a meaningful balance is real money for an afternoon of paperwork.
Inflation and tax
Two things reduce what your interest is worth.
Interest income is taxable as ordinary income at federal level, and at state level in most states. Your bank issues a form when interest exceeds the reporting threshold, and the income is taxable whether or not you receive a form.
Inflation reduces purchasing power. An account paying 4% during a year of 3% inflation gained you about 1% in real terms, before tax. This is worth knowing when deciding how much cash to hold beyond an emergency fund.
What savings accounts are good at
Cash in a savings account is liquid, protected up to federal deposit insurance limits, and not subject to market movements. That combination makes it right for money you might need at short notice: an emergency fund, a house deposit, a planned expense within a year or two.
It is the wrong place for money you will not need for decades. Over long periods, the gap between deposit yields and long-term investment returns compounds into a large difference. The question is not which pays more, it is when you need the money.
This article is general information about how consumer finance products work in the United States. It is not financial, tax or legal advice and is not a recommendation of any specific product or provider. Rules and pricing vary by state and by institution.