SoFi

When comparing different interest-bearing accounts, you may come across the terms APY (annual percentage yield) and interest rate. While similar, they are not the same thing.

The interest rate is the base rate the financial institution offers, while APY factors in how often that interest is compounded (or credited to the account). The more frequently interest is compounded, the faster your money grows, since interest is earned on previously earned interest more often. As a result, APY gives you a more accurate picture of potential earnings over time.

Ready to learn more about APY vs. interest rate and how each impacts your finances

APY and Interest Rate Defined

Both APY and interest rate indicate how much you’ll earn on your balance in a savings account, or other interest-bearing account, but there is a key distinction between the two.

What Is APY?

If you deposit money into any type of savings account, you will earn an annual percentage yield (APY) on that money. The APY is a useful number because it tells you how much you’ll earn on your deposits over the course of a year, expressed as a percentage. The APY calculation takes into account the interest rate being offered, then factors in whether or not the financial institution offers compounded interest.

Compound interest is the interest you earn on the interest you’ve already earned. Depending on the bank or credit union, interest may compound daily, monthly, quarterly, or annually. The more frequently interest compounds, the faster your money grows.

What Is an Interest Rate?

When it comes to a savings account, an interest rate is simply the percentage return you’ll earn on your original balance, without compounding. The higher the interest rate, the more you’ll earn on your deposits. But interest rate is only one component of the account’s APY, which also factors in compound frequency — or how often interest is paid.

When it comes to loans (e.g., a mortgage, car loan, or credit card), the interest rate refers to the price you pay for using that money. The higher the interest rate, the more you’ll pay back in addition to the principal amount. The interest rate on a loan doesn’t include any fees associated with the loan, such as origination fees, application fees, or other charges. To understand the total cost of a loan, you’ll want to look at its APR (annual percentage rate).

APY vs. Interest Rate Explained

Why does interest rate vs. APY matter? When you are opening a bank account, it can make a difference as one can give you a better picture of how your money will grow while on deposit.

The interest rate tells you the basic rate at which your money will accrue interest. The APY, however, gives you better insight to how much interest you will earn by the end of a year because it factors in the boost that compound interest can deliver.

Recommended: Different Ways to Earn Interest

The APY Formula

For those who want to delve in a bit deeper, the actual formula for APY calculation is as follows: (1 + r/n)ⁿ – 1.

•   The “r” stands for the interest rate being paid.

•   The “n” represents the number of compounding periods within a year.

If, for example, the interest rate is 3.50%, then that’s what you’d use for the “r.” If interest is compounded quarterly, then “n” would equal four.

The “n,” or compounding frequency, can cause two different savings accounts with the same interest rates to have different APYs. For example, if two different banks offer a savings account with the same interest rate but one compounds quarterly and the other compounds annually, that the account that compounds annually would have a lower APY than the account that compounds quarterly or daily.

Fortunately, if you want to compare savings rates from one bank or credit union to another, you don’t need to perform any in-depth calculations.

Financial institutions are required to provide information on APY as part of the Truth in Savings Act. And, here’s the heart of it all: The higher the APY, then the more quickly the money you deposit can grow.

Recommended: APY calculator

Calculating APR

The APR vs. interest rate of a loan tells you how much the loan will cost you over one year, including both the loan’s interest rate and fees, and is expressed as a percentage. A loan’s APR gives you a better sense of the true cost of the loan than the loan’s interest rate, since it includes fees. The higher the APR, the more you’ll pay over the life of the loan.

Thanks to the federal Truth in Lending Act, lenders must provide the APR of a loan. This allows you to compare loans apples to apples. A loan with a low interest rate but high fees may not be a good deal. In fact, you may be better off with a loan that charges a higher interest rate but no or lower fees. APR allows you to be a savvy consumer.

APR can be calculated with this formula:

APR = (((Interest + Fees ÷ Loan amount) ÷ Number of days in loan term) x 365) x 100.

Lenders will tell you the APR of a loan and you won’t need to perform any complicated calculations.

How Simple and Compound Interest Differ

With simple interest, no compounding is involved. If you were to deposit $10,000 in an account earning 4.00% simple interest, at the end of three years, your money would earn $1,200 for a total of $11,200.

If, however, the interest were compounded daily, you would earn around $408 the first year. The second year, interest would accrue on the principal and the interest earned in the first year, and you would earn roughly $425 the next year and then $442 the year after that, for a total of around $11,275.

While the difference in dollar amount may not seem earth-shattering in this example of a few years, when you are talking about your decades-long financial life, it can really add up. Your money will grow faster with compound interest, helping you reach your financial goals.

Types of High-Interest Accounts for Savings

If you’re looking to earn a competitive rate on your savings, you’ll want to compare accounts by looking at APYs, as well as account fees and balance minimums. Generally, you can find competitive rates by looking at high-yield savings accounts, money market accounts, and CDs.

•   High-yield savings accounts, typically offered by credit unions and online banks, are accounts that typically pay a substantially higher APY than the national average of traditional savings accounts. They generally also have low or no fees.

•   Money market accounts are savings accounts that offer some of the features of a checking account, such as checks or a debit card. They often come with a higher APY than a traditional savings account, but typically require a higher balance, such as $2,500 or more.

•   Certificates of deposits (CDs) also tend to pay a higher APY than a regular savings account but require you to leave your money untouched for a certain period of time, called a term. If you take money out before then, you’ll likely pay an early withdrawal penalty. CD terms typically range from three months to five years. Generally, the longer the term, the higher the APY (however, this isn’t always the case).

Recommended: How Does a High-Yield Savings Account Work?

High-Interest Checking Accounts

Checking accounts work well for everyday spending but typically offer no interest or very little. A high-yield checking account is a special type of account offered by some financial institutions (such as traditional and online banks, and credit unions) that offers a higher-than-average APY. These are accounts designed to give you the flexibility of a traditional checking account (with checks and/or a debit card) but with higher-interest returns.

A few points to note:

•   Some high-interest checking accounts will offer different APY tiers, with higher account balances earning a higher APY than lower account balances.

•   Often, to qualify for the highest rate the checking account has to offer, you need to meet certain criteria. This might be making a certain number of debit card transactions in a month, having at least one direct deposit or automated clearing house (ACH) payment each month, or choosing to receive paperless statements.

The Takeaway

When it comes to choosing a savings account, it’s essential to understand the difference between APY (annual percentage yield) and interest rate. While both relate to how your money grows, they aren’t the same.

The interest rate is the basic rate the bank pays you for keeping your money in the account and doesn’t account for compounding, while APY includes the effects of compounding.

When comparing accounts, it’s a good idea to look at the APY, since it shows the real return on your money and can help you select an account that maximizes your earnings.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

SOBNK-Q325-055

Leveraged exchange-traded funds (ETFs) are tradable funds that allow investors to make magnified bets on an underlying index. Leveraged ETFs have been popular among investors looking to amplify their exposure to a market with a single trade. But it’s important to know that leveraged ETFs are much more complicated than traditional ETFs, and they’re also higher risk.

Because they’re constructed to deliver multiples of the daily performance of the benchmark they track, investing in leveraged ETFs can lead to massive losses. And for reasons related to their inner mechanics, they’re not good for investors who may be looking for returns when held for an extended time.

How Do Leveraged ETFs Work?

Exchange-traded funds, or ETFs, are securities, and can embody a form of index investing. They’re typically baskets of stocks, bonds, or other assets that aim to mirror the moves of an index, though ETFs can have many different aims or goals. Leveraged ETFs use derivatives so that investors may potentially double (2x), triple (3x) or short (-1) the daily gains or losses of the index. Financial derivatives are contracts whose prices are reliant on an underlying asset.

In finance, leverage is the practice of using borrowed money to increase the potential return on an investment. Leveraged ETFs use derivatives to increase the potential return on an investment.

Let’s look at a hypothetical example. Say an investor buys a regular, non-leveraged ETF. Here’s how such an ETF would work. If it tracks the S&P 500 Index and the benchmark gauge rises 1% on a given day, the non-leveraged ETF would also climb about 1%.

If, however, the investor buys a triple leveraged ETF or 3x ETF, their return for that given trading day could be a 3% gain. The reverse scenario could also happen, though. If the S&P 500 fell 1% on a given day, the owner of the triple leveraged ETF can suffer a 3% loss.

Most of these ETFs are designed to try to outperform a benchmark or index’s daily performance, and holding them longer than a day could result in losses, as such. Accordingly, they’re not intended for long-term investing strategies.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is “Decay” in Leveraged ETFs?

There are pros and cons to ETFs themselves. But leveraged ETFs can be particularly problematic for investors due to their design. They are constructed to deliver multiples of an underlying asset’s daily returns, not weekly, monthly or annual returns. Leveraged ETFs don’t deliver the exact magnitude of 2x or 3x if held for longer than a day.

So, if the S&P 500 were to rise 5% in a week, a triple leveraged S&P 500 would not climb 15% in that week. The same would be true for a double leveraged ETF. There’s no guarantee it would return 2x or 10% to its owner.

That’s because of how leveraged ETFs are constructed. In order to maintain their 2x or 3x exposure, leveraged ETFs use derivatives that need to be rebalanced at the end of each day. This process can erode the returns of the ETFs — a process known as “decay” in the market.

Types of Leveraged ETFs

Here are some of the types of leveraged ETFs on the market:

•   Double Leveraged (2x) ETFs give investors double exposure to the daily return of an index of stocks, bonds, or commodities. So if an asset or market moves 1.5% in a single day, the fund aims to deliver a return of 3% that day.

•   Triple Leveraged (3x) ETFs try to provide investors with 3x amplification. So if the underlying asset or index rises or falls 2% on a trading day, the ETF seeks to rise or fall 6%.

•   Inverse (-1) ETFs are also considered to be leveraged ETFs. They move in the opposite direction of the underlying asset they’re designed to follow. So if an index moves -1%, the ETF would aim to climb 1%, and vice versa. Inverse ETFs are essentially a form of shorting a stock. Investors are able to short the underlying market by buying shares of an inverse ETF.

Pros of Leveraged ETFs

Some of the advantages of leveraged ETFs include the following:

Easy Leveraged Trades

Leveraged ETFs have made it easier for investors to make leveraged wagers on the market, which can be a day-trading strategy but not a practice that’s readily available to all investors, particularly retail investors at home who may be trading in smaller increments.

Useful For Quick Leveraged Market Wagers

Leveraged ETFs can be useful for a one-day wager that an investor wants to make on an underlying market, such as technology stocks, high-yield bonds, or emerging markets.

Allow For Easy Shorting

Inverse ETFs can give investors the ability to short, or bet against, an asset. Short sales aren’t easily available to non-professional investors, particularly retail investors at home. Shorting can be a way for investors to hedge or offset the risk in their holdings.

Cons of Leveraged ETFs

Some of the potential disadvantages of leveraged ETFs include the following:

Potential For Outsized Losses

With leveraged ETFs, investors could potentially see outsized losses due to how the products compound returns. For instance, if an index were to tumble 3% in a single day, a holder of leveraged ETFs would experience a plunge of 9% in the shares of their fund.

Increased Investment Risk

Inverse ETFs allow investors to short assets, but because of how there’s no limit to how high an asset can go, that means investors could see their holdings in the inverse ETF go to zero.

Derivative Risks

Leveraged ETFs use derivatives to achieve their amplified returns. Therefore, investors should be aware of the counterparty risk — or the risk from the other parties involved in the derivatives.

Higher Costs

Leveraged ETFs tend to be more expensive than traditional ETFs. Investors who want to understand how fund fees work should look at the ETF’s expense ratio. For instance, some popular leveraged ETFs can have an expense ratio of 0.95%. That compares with more traditional ETFs, which can have an expense ratio of around 0.20%.

Closure Risks

There’s a high risk of closure. Investors who don’t sell out of their leveraged ETF shares before the delisting date could be left with positions that are difficult or costly to liquidate.


💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Regulation of Leveraged ETFs

Regulators’ rules on leveraged ETFs have varied in recent years. And they continue to change.

Most recently, in early 2023, the Securities and Exchange Commission (SEC) issued a bulletin about leveraged ETFs, warning investors about the particular risks associated with them.

In October 2020, the SEC made a rule change that would make it easier to launch leveraged ETFs, while capping the amount of leverage at 200%. The move was a break away from prior announcements that sought to slow down the creation of new leveraged ETFs. The SEC had previously allowed existing leveraged ETFs to be continued to be traded, while putting restrictions on the approval of new such funds. The SEC issued an alert about leveraged funds to retail investors in 2009.

In May 2017, the SEC approved the first quadruple (4x) leveraged ETF, only to halt its decision soon after.

Some investment firms and ETF providers have pushed for the term “ETF” to not be applied to leveraged and inverse funds. They argue that the term “ETF” is used for a range of products that can lead to significantly different outcomes for investors.

The Takeaway

Leveraged ETFs use derivatives in their construction to try to deliver amplified returns for an investor. Relative to index funds, ETFs can allow entire markets to be more easily traded, similar to how shares of a stock are traded. Leveraged ETFs are not safe for all investors, particularly inexperienced ones.

These ETFs can cause massive losses because of how they may magnify returns and losses. In addition, market observers and regulators have said that leveraged ETFs may be better suited for professional or experienced investors to be used within a single trading session. The use of derivatives in such funds causes their performance to veer from the underlying market if the ETFs are bought and held. As always, it’s important to do your research about any ETF or investment before investing.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

FAQ

What are examples of different types of leveraged ETFs?

There are several types of leveraged ETFs, including double leveraged (2x) ETFs, which give investors double exposure to the daily return of an index of stocks, bonds, or commodities. There are also triple leveraged (3x) ETFs that try to provide investors with 3x amplification. Inverse (-1) ETFs are also considered to be leveraged ETFs. They move in the opposite direction of the underlying asset they’re designed to follow.

What are some drawbacks of leveraged ETFs?

Leveraged ETFs allow for the potential of outsized losses, introduce additional investment and derivative risks, and may have higher associated costs than traditional ETFs.

Are leveraged ETFs good for beginning investors?

Leveraged ETFs are not intended for beginning investors, as they’re more complex, and have additional risks. As such, traditional ETFs may be a better option, depending on the specifics of an investor’s situation.