Interest calculation from an APY on a bank account

Bank accounts are full of jargon and sometimes it can be confusing to understand all of the terms.

I got an email the other day from someone who had some questions about opening a bank account. Specifically, the person was curious about how the APY was calculated and how that related to interest earned:

Presh, could you help me understand what an APY of 0.05% means? I want to start a money market account, and the bank says that their annual percentage yield is 0.05% and that the interest is compounded daily and paid monthly. The amount of interest earned is based on the daily collected balances in the account. I really don’t understand what all this means.

If I deposit $5000 into the account, how much interest can I expect? That’s all I want to know. I don’t understand how to figure out the interest using the above information that the bank has provided. Thanks

This is a very good question, and I felt it would be educational to discuss the details of the bank account.

The big picture: how much interest

Carol primarily wanted to know how much money she would earn on a $5,000 deposit.

The APY is the relevant piece of information here. APY stands for annual percentage yield, and it represents the percent interest one can expect to earn, taking into account for the effects of compounding.

In this case, the 0.05% APY means that you earn 0.05% interest on your money in a year. So if you deposit $5,000, then you can expect to earn $2.50 in interest (0.05% * $5000) by the year end.

(This is a really small sum of money. As you are probably aware, there are online savings accounts with higher APY. Banks like ING and Ally Bank are currently offering something like 0.8%, which would translate into $5,000 earning $40 in interest per year.)

The APY is the most important detail in the email. But there are a few subtle points that also merit discussion.

Payment frequency: interest paid monthly

This is a very important detail. This tells you the bank only credits the interest to your account once a month on a specified day.

It helps to know when the interest is paid, especially if you are closing the account. You can lose out on interest if you close out just before a payment. For instance, if you expect an interest payment of say $50 on the 15th of the month, but you happen to close the account on the 14th, then you would lose out on that $50.

In the account mentioned in the email, we expect to earn $2.50 a year, so that comes out to about 20 cents each month paid on a specific day.

Balance calculation: daily collected balances

This is another important detail. Unlike a CD where you invest a fixed amount of money, a money market account will change depending on withdrawals and deposits.

Because your balance can change daily, the bank has to specify which balance it uses for computing interest.

The daily collected balance is one method banks often use. The daily collected balance method says the following: you take the closing balances for each day of the month for collected funds (deposits that have not cleared are uncollected funds), and then take the average.

For example, if you started with $5,000 and then on the 15th day withdrew $1000, then you’ll have $4000 for another 15 days. So if you have $5000 for half the month, then $4000 for half the month, your average daily collected balance would be $4,500.

Compounding frequency: interest compounded daily

This is a final point that I wanted to talk about from the email, though it is not as important.

In theory, it matters whether interest is compounded on a daily or monthly basis. The shorter the compounding period, the more interest that will get accumulated over a year. Here is an article that shows how daily compounding results in slightly more interest than monthly compounding: daily vs monthly compounding.

But we don’t really need to concern ourselves with this detail. The reason is that the bank account quoted an APY, which already takes into account the effect of compounding. If you have two accounts with the same APY, they can expect to give you the same interest at the year end. The effect of monthly versus daily compounding is already accounted for in the APY.

The only time you care about the compounding frequency is when you are comparing APR (annual percentage rate) rather than APY (annual percentage yield).

Typically the APR is quoted for credit cards, and APY for savings accounts, a practice that I have explained before in this article: APR vs APY: what is the difference?.