What Is the Annual Percentage Yield (APY)?
The annual percentage yield (APY) is the real rate of return earned on an investment, taking into account the effect of compounding interest. Unlike simple interest, compounding interest is calculated periodically and the amount is immediately added to the balance. With each period going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.
The annual percentage yield (APY) helps a business or investor to understand how much they are earning from the money they have invested with compounded interest. In other words, how much are you earning on your invested money over the course of a year if the interest is compounded?
The term, “compound interest”, essentially means the interest has been reinvested. Your cash contributions earn interest, which stays in the investment and becomes part of the principal balance. As time goes on, the value of your interest earned will be greater because of all the prior interest added to the principal.
For example, if you invest $100 with a 10% interest rate per month, then after the first month you will have $110. The second month’s interest earned would be $11, totalling to $121. The third month’s interest earned would be $12.10, totalling to $133.10, and so on. As you can see, the more time your capital has to spend with its compound interest, the more money you can make. With accounts like these, the earlier you can begin investing, the better.
What does APY mean?
APY refers to the amount of money, or interest, you earn on a bank account over one year. Of note, this includes compound interest. An interest rate is similar to APY except it doesn’t factor in compounding.
Simple interest doesn’t compound, so you earn the same amount of interest every month. Compound interest, meanwhile, is the interest earned on both the money you put into the account and the interest you receive over time.
The higher a savings account’s APY, the better. Many online banks offer APYs around 0.40%. (You can read more about some of NerdWallet’s favorite high-yield accounts here.) The national average is just 0.06%
If you’re willing to lock away some of your savings for a set period of time, consider a certificate of deposit, or CD. Some online banks have CD rates around 0.55%. (See NerdWallet’s list of the best CD rates.)
When the APY is the same as the interest rate that is being paid on a person’s investment, he is earning simple interest. When the APY is higher than the interest rate, however, the interest is being compounded, which means he is earning interest on his accumulating interest.
People sometimes confuse APY with APR. APR refers to the annual interest rate without taking compounding interest into account. APY, on the other hand, does take into account the effects of compounding within a year. The difference between the two can have important implications for borrowers and investors.
When banks or other financial institutions are looking for clients for interest-bearing investments, such as money market accounts and certificates of deposit, it is in their best interests to promote their best APY, not their APR. APY is higher than APR, so it looks like a better investment for the client.
The more frequent the compounding periods, the higher the APY. Thus, people who save money in their bank accounts should check how often the money is compounded. Typically, daily or quarterly is better than annual compounding, but make sure to check the quoted APY for each option beforehand.
How Annual Percentage Yield Works
When you deposit funds into a savings account, money market, or certificate of deposit (CD), you earn interest. APY can help you tell how much interest you’d earn on the account over one year. It’s based on the interest rate and the frequency of compounding, and it shows you the interest you would earn on the principal (original deposit) plus interest on earnings.
Annual Percentage Yield Formula
The general formula to calculate the annual percentage yield (APY) is expressed using the following mathematical equation:
Where:
- i – the nominal interest rate
- N – the number of compounding periods
APY should always be expressed in a percentage. Also, this formula looks at the percentage yield for one year at a time.
Consequently, you should be looking at the annual interest rate for the variable i. Now, there are different types of interest rates. Different accounts and banks will have differing terms set on their interest rates. Some may compound monthly while others compound annually. Your annual percentage yield will be higher if your interest is compounded more frequently.
What Annual APY Can Tell You
Any investment is ultimately judged by its rate of return, whether it’s a certificate of deposit (CD), a share of stock, or a government bond. The rate of return is simply the percentage of growth in an investment over a specific period of time, usually one year. But rates of return can be difficult to compare across different investments if they have different compounding periods. One may compound daily, while another compounds quarterly or biannually.
Comparing rates of return by simply stating the percentage value of each over one year gives an inaccurate result, as it ignores the effects of compounding interest. It is critical to know how often that compounding occurs, since the more often a deposit compounds, the faster the investment grows. This is due to the fact that every time it compounds the interest earned over that period is added to the principal balance and future interest payments are calculated on that larger principal amount.
APY vs. APR
Although both the annual percentage yield (APY) and annual percentage rate (APR) are representations of an interest rate, there is a significant distinction between the two terms. Unlike the APY, the APR does not consider compounding effects.
As mentioned above, the primary advantage of the APY over the APR is the standardized representation of interest rates. In other words, the former can be utilized to compare products with various compounding structures for interest rates.
Since the APY takes into consideration the compounding effect, it will be higher than the APR. Due to this reason, financial institutions tend to prefer to quote the APR in their loan offerings, as the lower rate makes their deals appear more attractive to potential customers.
For the same reason, the annual percentage yield is frequently reported in the offerings of investment products or interest-earning bank accounts, as the APY figure will appear more attractive to investors.
Annual Percentage Yield Analysis
The annual percentage yield is a means to understand how much money you will actually be taking home from an investment where interest is compounded. It can be very useful in comparing different accounts that you are considering.
Typically, if you are the one who is investing, then a higher APY is better. If you are deciding on a CD or savings account, you can calculate the APY to figure out which will ultimately give you the better return. On the other hand, APY can also mean additional money you are charged. If you have a balance on your credit card, you can be charged a compounded interest on your balance, meaning that you pay more over time.
You may be tempted to confuse APY with APR, or annual percentage rate, which is similar except that it only looks at a basic interest rate, not a compounded one. Depending on the type of investment you’ve made, the annual percentage yield can be more accurate since it will tell you the actual value at the end of the investment period. If you have two investments with the same interest rate, the actual value of their return could be very different if one of the accounts had compounding interest.
However, with all the intricate legal jargon that comes with bank account documents, it can be difficult to identify these variables. Thankfully though, in the U.S. it is a federal law that banks have to disclose their interest rates, including APY, along with any potential fees associated with the account. This is meant to help individuals more accurately compare the future of their investment.
Annual Percentage Yield Conclusion
- The annual percentage yield is the cash earned from an investment over a year.
- The annual percentage yield includes compounded interest in its calculation.
- The annual percentage yield formula requires 2 variables: interest rate and the number of compounded periods per year.
- A higher APY is better for investments, like savings accounts, while a lower APY is better for loans or credit, like a credit card.
Frequently Asked Questions
What is the annual percentage yield (APY)?
The annual percentage yield, or APY, is a measure of the interest rate on an investment that takes into account the frequency of compounding. This means that it gives you a more accurate estimate of the actual return you can expect from the investment. The APY is important to know because it can help you compare different accounts and investments.
How is annual percentage yield calculated?
The annual percentage yield is typically calculated by multiplying the interest rate by the number of compounded periods per year. However, there are a few different formulas that can be used to calculate APY.
What is the difference between annual percentage yield and annual percentage rate?
The annual percentage rate, or APR, is a measure of the basic interest rate on an investment. The APY takes into account the frequency of compounding, which gives a more accurate estimate of the actual return.
What is a good annual percentage yield?
There is no one answer to this question since the annual percentage yield can vary depending on the investment. However, a higher APY is typically better because it means you will earn more money on your investment.
How does annual percentage yield work per month?
If an investment compounds monthly, then the APY would be calculated by multiplying the interest rate by 12 (the number of months in a year). This means that the APY would be higher than if the investment only compounded annually.