Annual Percentage Yield (APY) is the rate of return on funds kept in a bank account based on interest earned over an entire year. When choosing where or how to save money, understanding APY is essential as it can help you better understand how much your money will grow in value over time.
What Is Annual Percentage Yield?
Annual percentage yield is the most common way to measure interest earned on savings accounts, and it can also be applied to some checking accounts. The higher the APY is, the more interest the account will accumulate over time. The higher the APY, the faster your saved money can grow.
You can earn two common types of interest on your savings: compound and simple interest.
With compound interest, the interest you earn on your money is added to your account each compounding period. Then, that additional money also earns interest over time. This way, the amount you earn in interest keeps adding to your balance, and your money grows more quickly. Compounding can occur daily, monthly, quarterly, or annually depending on the account.
The second type of interest, simple interest, is more straightforward. It is the amount added to your principal balance in the account, meaning it does not compound or build on itself over time.
APY calculations are used for accounts that offer compound interest.
How Is It Calculated?
Calculating APY can be confusing because it requires considering the compounding component of the investment. There is a formula you can follow:
(1 + r/n)^n – 1 = APY
In this formula, “r” is the interest rate, and “n” is the number of compounding periods. If your account compounds at a rate of one time a month, then “n” would be 12 for 12 times a year.
Most of the time, you do not have to calculate this figure yourself. By law, financial institutions must disclose the APY a savings account earns.
Calculating APY starts with knowing how often the account will compound interest, and this may be every month or even every day. When choosing an account, if interest rates are the same, accounts with more frequent compounding will have a higher APY.
Differences From Interest Rate
Don’t confuse APY with the annual percentage rate (APR). It’s easy to confuse these two figures, but they are applied differently.
APR refers to the interest you pay on a debt, like a credit card or mortgage loan. APY is the amount you earn from investing your money into a savings account or another type of investment.
APR is an important figure. If you are borrowing money to buy a car or home or comparing several credit card offers, you will want to seek out the lowest APR possible, which means you’ll pay less on the borrowed funds.
Using APY to Compare Rates
As you look for ways to save money, consider all aspects of the account. APY is one of those crucial factors. You want to choose an account with a higher APY in nearly all cases. That means the funds you put into the account will grow in time at a faster rate.
Be careful, though. Some accounts with a high APY could also have high fees, and some may have minimum account balance requirements, which could be a trade-off in some situations. Be sure to determine the best option based on overall costs and the flexibility the account offers you.
Before you save and open an account, ask your bank or financial institution about all accounts that earn interest. Compare them to determine which one best meets your needs. Initially, a savings account may be ideal. Over time, look at other saving options, including certificates of deposit.
APY will differ from one financial institution to the next and can also change over time. Comparing several financial institutions can help you determine your best route for saving and earning the most from your investments.