APY, or annual percentage yield, is a banking term used to measure how much interest you will earn on a bank account for one calendar year. APY includes the compounding interest, which is the interest paid on both principal and earnings. APY is calculated using the annual interest rate and the frequency of compounding periods each year.
APY vs APR
APY is the interest you earn on a bank account, like checking accounts, savings accounts, certificates of deposit (CDs), and money market accounts. This is the amount of interest the bank pays you for your deposit. Meanwhile, an annual percentage rate (APR) is the interest that you pay on borrowed money like on loans or credit cards.
Why Is APY Important?
APY is important because it allows you to compare the interest rates of different banks for bank accounts. Knowing the APYs for different bank accounts makes it easier for you to understand how it can affect your overall savings. It can also help you choose the right bank that can provide the best value for your money.
It’s important to know the APY on your account because it allows you to compare the amount you are earning to another account easily. While two banks may offer accounts with the same interest rates, they may compound differently, resulting in a different APY. When you know the APY of both accounts you are comparing, you can be assured that you are comparing apples to apples.
How APY Works
APY works by taking into consideration the interest rate and the number of compounding periods every year.
For example, a CD account has an interest rate of 1.50% and an APY of 1.51%. The 0.01% difference between the interest rate and the APY is the effect of compounding. Let’s say this account pays interest on a monthly basis. If you make a $5,000 deposit and earn a simple interest of 1.50% annually, your balance will become $5,075 after 12 months.
Since you earn interest every month and compounding lets you earn interest on the interest credited to your account, you’re going to get a little more interest than the previous month. The monthly compounding lets you earn 1.51% interest over a year. If we use the example above, your balance after 12 months would be $5,075.50. The additional 50 cents is the result of the compounded interest earned on the account. This 0.01% difference will have a significant effect on how much you earn on your account if you have a higher balance.
How to Calculate APY
The basic formula to calculate APY is as follows:
APY= (1 + r/n )^n – 1
Based on the formula, “r” refers to the stated annual interest rate, and “n” represents the number of compounding periods each year. The frequency of compounding periods per year—whether the interest is compounded daily, quarterly, or monthly—can affect the overall APY greatly.
For example, let’s say the annual interest rate of a high-yield deposit account is 4%, and it pays interest on a monthly basis. Using the formula, we calculate the APY as follows:
APY = (1 + 0.04/12)^12 – 1
APY = 4.074%
If the account pays 4% annual interest on a daily basis, the APY is calculated as:
APY = (1 + 0.04/365)^365 – 1
APY = 4.081%
The two given examples show that the number of compounding periods each year can affect the APY. The more frequently interest is compounded, the higher the APY will be. Higher APYs can have a significant impact on your earnings, especially if you have a higher account balance.
Variable APY vs Fixed APY
Some bank products, such as investment accounts, have a variable APY. This means that the APY may increase or decrease based on market conditions. There are certain bank products, such as CDs, that offer a fixed APY, which means you will receive the same rate from the date you open the account up to the end of the term.
What Is a Good APY?
The value for a good APY depends on the specific type of deposit account. Generally, a high-yield savings account earns rates that are much better than the national average, typically around 0.50% APY.
Bottom Line
APY is an important way to measure how much you will earn on a bank account over a year, taking into consideration the number of compounding periods each year. With APY computation, compound interest is added periodically to the total invested amount, increasing the total balance. The frequency of compounding periods in a year can have a significant impact on how much interest you can earn.
