how compound interest works
the premise of apy is rooted in the concept of compounding or compound interest compound interest is the financial mechanism that allows investment returns to earn returns of their own imagine investing 1 000 at 6 compounded monthly at the start of your investment you have 1 000 after one month your investment will have earned one month s worth of interest at 6 your investment will now be worth 1 005 1 000 1 06 12 at this point we have not yet seen compounding interest after the second month your investment will have earned a second month of interest at 6 however this interest is earned on both your initial investment as well as your 5 interest earned last month therefore your return this month will be greater than last month because your investment basis will be higher your investment will now be worth 1 010 03 1 005 1 06 12 notice that the interest earned this second month is 5 03 which is different from the 5 00 from last month after the third month your investment will earn interest on the 1 000 the 5 00 earned from the first month and the 5 03 earned from the second month this demonstrates the concept of compound interest the monthly amount earned will continually increase as long as the apy doesn t decrease and the investment principal is not reduced banks in the u s are required to include the apy when they advertise their interest bearing accounts that tells potential customers exactly how much money a deposit will earn if it is deposited for 12 months 1variable apy vs fixed apysavings or checking accounts may have either a variable apy or fixed apy a variable apy is one that fluctuates and changes with macroeconomic conditions while a fixed apy does not change or changes much less frequently one type of apy isn t necessarily better than the other while locking into a fixed apy sounds appealing it could also mean missing out when the federal reserve is raising rates and apys increase each month most checking savings and money market accounts have variable apys though some promotional bank accounts or bank account bonuses may have a higher fixed apy up to a specific level of deposits for example a bank may reward 5 apy on the first 500 deposited then pay 1 apy on all other deposits apy and riskin general investors are usually awarded higher yields when they take on greater risk or agree to make sacrifices the same can be said regarding the apy of checking saving and certificates of deposit 