When you’re comparing savings accounts or loans, the terms APY (Annual Percentage Yield) and interest rate often appear side by side. They measure two different things. The interest rate shows the raw percentage you’ll earn or owe on a principal amount, while APY takes it for the effects of compound interest.
Understanding APY vs interest rate can help small business owners choose the best savings account to grow their funds or evaluate the true cost of a loan.
APY: What It Is and How It Works
APY shows the interest an investment will earn in a year. It includes the interest on interest, unlike simple interest. The formula to calculate APY is:
APY = (1 + r/n)ⁿ – 1
Here “r” represents the stated annual interest rate, while “n” represents the number of times compounded
What Is an Interest Rate?
The interest rate is the percentage you earn or owe on a principal amount, but it doesn’t account for compounding. For savings accounts, this means your earnings are based only on the original balance, without the boost provided by compound interest.
For loans, the interest rate represents the cost of borrowing before additional fees or compounding effects. It’s an important starting point but doesn’t tell the whole story, especially for long-term loans where compounding increases your repayment costs.
Examples of Interest Rate Calculations
Let’s see how these work with examples:
| Principal | Interest Rate | Compounding Period | Simple Interest | Compound Interest |
|---|---|---|---|---|
| $1,000 | 5% | Annually | $50 | $51.16 |
| $1,500 | 3% | Monthly | $45 | $45.68 |
Example: Simple vs. Compound Interest
Let’s say you invest $1,000 at a 5% annual interest rate. With simple interest, you’d earn exactly $50 each year. But with compound interest, your earnings increase annually.
- Year 1: $50
- Year 2: $52.50 (interest on the $1,050 balance)
- Year 3: $55.13
After three years, you’d earn $157.63 with compound interest compared to just $150 with simple interest. This difference grows exponentially over time.
APY vs interest rate: What’s the difference?
The difference between interest rate and APY is compound interest. APY gives a clearer picture of your earnings because it includes compounding interest. For example, a savings account with a 4.60% APY grows your money faster than a simple interest rate.
APY and interest rates affect savings and loans differently. APY shows the potential growth in savings, especially in high-yield accounts. The Truth in Savings Act requires banks to show APY, making it easier to compare rates. For loans, knowing both the interest rate and APR is crucial for making smart choices.
Interest Rate vs APY: Save Your Business Money
Understanding APY and interest rates can save your small business money by helping you make smarter financial choices. For savings, focus on APY to grow your funds faster with compounding interest.
For loans, don’t just look at the interest rate—factor in how fees and compounding add up. This knowledge keeps you from overpaying and gets you the best deals. Choosing a high-yield savings account or avoiding costly loans can boost your bottom line. It’s all about making your money work harder for you.
Conclusion
Knowing the difference between interest rates and APY is key for small businesses. By choosing high-APY accounts, business owners can boost their earnings. This helps them make wise financial choices that aid in their growth and health.
Looking at examples, APY’s effect on savings is clear. For example, a $1,000 account with a 1% interest rate grows over time. On the other hand, a $20,000 deposit with a 5% daily compound APY can earn $5,680.07 in five years. Also, comparing a CD and a high-yield savings account with a 5% interest rate shows big differences in earnings.
Want to make smarter financial choices for your small business? Visit JC Castle Accounting to learn how we can help you optimize your savings and loan decisions!
