The only thing worse than the meager rates being paid to savers these days is the confusing language used to define those rates. The financial industry has stirred up a stew of acronyms, abbreviations, and indecipherable descriptors — APY, 7-Day Yield, SEC Yield, Effective Yield, and more — all ironically intended to add clarity.
The lack of clarity came to light recently via the story of one particular SMI member. After staring in disbelief at the 7-Day Yield listed in the Money Rates table of the SMI monthly newsletter, he couldn't believe savings rates could really be as low as the numbers seemed to suggest. So, figuring it must be the interest rate for one week, he multiplied it by 52. Ah, if only…
Let's cut through the financial fog to help you understand how little interest your savings are really earning.
APY – annual percentage yield
Listed first in the Money Rates table are some of the highest money market account rates offered by banks around the country. The rates listed are the annual percentage yields, or APY. That's the percentage of the balance that will be earned in interest in one year, assuming you don't make any deposits or withdrawals and the funds remain in the account that long.
To figure out how much you'll earn, multiply the amount you have in savings by the interest rate. For example, if you have $3,000 in an account paying an APY of one percent, at the end of one year your account will have earned $30 in interest.
Importantly, APY does factor in the impact of compound interest no matter what compounding method is used. If one bank compounds daily and another compounds monthly, the APY accounts for that, allowing you to compare how much you would earn in a year from each institution no matter how often the interest is compounded.
Banks and credit unions are required to display APY when indicating the interest rates offered on their savings products, such as passbook savings accounts, money market accounts, and certificates of deposit (CDs).
Of course, an institution's APY can change at any time, unless it is previously locked in, as with a CD.
Also listed in the Money Rates table is the 7-Day Yield for some of the higher-yielding money market funds. Whereas money market accounts are interest-bearing savings accounts offered by banks and credit unions, money market funds are mutual funds offered by investment companies. Both are considered very safe places to keep savings. However, bank-sponsored money market accounts are insured; money market funds are not.
The other key difference is that money market funds are required to state their interest rate as a 7-Day Yield. As with the use of APY by banks and credit unions, the intent is to give people an apples-to-apples way to compare rates offered by different money market funds. Some investment companies use other descriptors that mean the same thing, such as SEC Yield or SEC 7-Day Yield.
In essence, the 7-Day Yield is the annualized equivalent of what the fund earned for its shareholders over the past week. However, compounding is not part of the equation. To see the rate with compounding factored in, look for the 7-Day Effective Yield, which is also sometimes referred to as the Compound Yield. Fortunately, most companies that offer money market funds list both the 7-Day Yield and the Effective or Compound Yield. Right now, with interest rates so low, the difference is negligible. However, when interest rates rise, the difference will become more apparent.
You'll notice in the Money Rates table that we also list some of the highest-rate tax-free money funds. Since earnings on such funds are exempt from federal income tax, we show the impact on the 7-Day Yield for anyone in the 25 percent tax bracket.
Putting this information to use
Clearly, the financial services industry's attempt at making it easier for people to compare rates offered by different savings products still has a ways to go. For now, the best way to compare the rates offered by banks and credit unions with the rates offered by money market mutual funds is to use the bank or credit union account's APY and the money market fund's Effective or Compound Yield. These are the measures that include the impact of compound interest.
This article may not make you feel any better about how much interest you're currently earning from your savings. But at least you now understand what the numbers mean.