What is APY and how can it benefit my savings?

Saving money is an important component of smart personal finance, as is ensuring that you’re getting the most out of the funds you’ve worked hard to save. Although there are many different ways to save, as well as a variety of account types to store your cash in, one key thing to always consider is Annual Percentage Yield, or APY.

Have you ever looked at several banks or financial institutions and wondered why the APY is different from place to place? In short, APY can be a kind of promotional game in the banking industry—but it’s one that actually benefits you if you know what you’re looking for and read the fine print.

Here, we’ll delve into the basics of APY, why it differs from bank to bank, and why you should keep it top of mind when it comes to getting the most bang for your buck.

What is APY?

APY is an acronym for Annual Percentage Yield and is a percentage rate that shows the total amount of interest you can earn on a bank account. It’s based on your interest rate and how often the balance compounds over one year. 

Although some checking accounts pay interest, APYs are typically higher with savings accounts, money market accounts, and Certificates of Deposit (CD). The higher the APY, the more you can earn on the money you have in that account. For example, if you have $10,000 in savings, you’ll earn $2 with 0.02% APY and at 2.00%, you’ll earn $200.

Compound interest is when both your principal amount and accumulated interest earn interest, which can help you earn more on your money faster. Depending on the terms of your account, interest can compound daily, quarterly, monthly, or yearly. If your interest compounds more frequently, you can generally earn more, especially with a higher APY.

APYs can be fixed or variable. A fixed rate will pay the same interest rate for a specific amount of time (or even the lifespan of the account), whereas a variable rate can fluctuate from the

initial rate when you opened the account. This is often tied to the Federal Funds Rate, and a rate hike can sometimes translate to an increased APY on some savings accounts.

Your bank or financial institution has to disclose the account APY and the compound interest frequency, so always make sure to get those details up front. If you're shopping around for somewhere to stash your funds and earn interest, make sure to consider APY, as well as annual or monthly fees, in order to fully understand what you're getting from the account before opening it and depositing funds. 

Also, keep in mind that many of the places offering the highest APY have other catches, like a minimum balance requirement or a fee if you don’t hold the minimum balance.

As you compare what different banks and institutions offer, you may be wondering what’s behind such a wide range of available rates, so let’s discuss why this is the case.

Why does APY range so much?

Reason #1: Banks may use APY to promote deposits so they can make loans.

In the world of banking, your cash—whether it’s in your bank account or savings account—is a deposit, and banking institutions rely on these deposits to support other parts of the business, such as granting loans. To incentivize you to make deposits, a banking company might raise its rates.

“Deposits are the fuel that drives the lending engine,” said Greg McBride, Chief Financial Analyst for Bankrate.com. “When banks have higher loan demand, they have higher deposit needs to feed the machine.”

Reason #2: Every banking institution has a different cost structure.

Online-only banks may have lower expenses than brick-and-mortar banks, as they don’t have to pay as much for bank branches and associated personnel and upkeep costs. “The lower cost base gives them more latitude,” said McBride, which is one reason you may see online and app-based savings accounts offering higher interest rates and charging fewer fees.

Online banks and high-yield savings accounts tend to offer the highest rates, and when one financial institution raises rates, the rest may follow. “Among the top-yielding accounts, it’s very competitive,” said McBride. “They continue to raise payouts and leapfrog each other.”

Even with their branches, credit unions also have more latitude because they’re nonprofits, said McBride. “But they may decide to invest in more products or services rather than [higher] returns.” Credit unions that do offer higher rates may do so with high-yield checking accounts, which require members to meet certain criteria (such as regularly using the debit card or logging into their account) to receive the higher rate.

Why don’t the largest banks have competitive rates?

If customers can get a higher rate by switching accounts, why don’t big banks offer the same or higher interest rates than online banks and credit unions?

In short, it’s because they don’t need your money. They tend to have less need for consumers’ deposits, as they may have large deposits from businesses or investors. “The big banks that have the most market share also have the most pricing power,” says McBride. “They don’t need to pay higher rates on deposits because their vast branch [networks] and ATM networks act as a catcher mitt.”

In other words, collecting fees on other services could offset the need to attract consumer cash deposits to use for a lending business.

By offering a wide range of products, big banks also tend to attract customers who want to do all their banking with one company rather than shopping around. Once they’re customers, people can be hesitant to change banks.

Companies like Varo are challenging these big institutions—offering a suite of banking services with no fees and high rates.

So while traditional banks might hope you’ll stick around because it’s time-consuming to move on, it really does pay off for people to do some comparison shopping when it comes to finding the bank that offers them the most.

Finding a higher APY for your money

Does it make sense to switch from an account that offers 0.02% interest to 0.03%? Probably not. But the difference between big banks’ rates and online and mobile banking rates is often much larger.

“What really counts is the buying power of the money,” says McBride. “If you’re earning a rate of return that isn’t keeping pace with inflation, you’re losing buying power.” 

There’s more to consider than just interest rates when comparing bank and savings accounts, however. You’ll also want to consider all the fees that could be also included.

Convenience is a factor to consider as well—the ease with which you can get money in and out of your savings account is important. However, if you find a savings account that offers a higher rate, no fees and is easy to use, it could be worth switching.

“If you’re sitting back and waiting for the big bank to bestow higher rates you’ll be sorely disappointed,” said McBride.

Getting a high APY with a Varo Savings Account

Want your money to work for you? The Varo Savings Account offers one of the highest savings rates in the country (3.00% starting Annual Percentage Yield¹), no fees, and no minimum balance requirements. Compare that APY to the national average of 0.37%².

Plus, you can grow your balance over time without even thinking using our automatic savings tools, Save Your Change and Save Your Pay. These tools can help you practice smart ways to save without interrupting your daily life.

No matter where you decide to keep your savings, it’s important to understand how APY works and why it can work in your favor with the right account. As we said before, always make sure to read the fine print before opening an account so that you can rest easy that you’re getting the most out of the money you worked hard to save.