Annual Percentage Yield (APY) - Definition, How to Calculate?
If you want to open a bank account, one key factor to evaluate is the APY or Annual Percentage Yield. The APY represents the total interest your money could earn in a year through deposits and savings products like high-yield savings accounts and certificates of deposit (CDs).
Calculating the APY allows you to estimate the growth rate for your money over time. And securing the highest APYs leads to maximizing your interest earnings potential.
But how do you actually determine the APY? This guide breaks down the key things you need to know about how annual percentage yield works and how to evaluate APYs to boost your savings potential.
What Is the Annual Percentage Yield (APY)?
It's important to understand the difference between simple interest and compound interest when evaluating interest earnings on bank accounts, which make up the Annual Percentage Yield (APY).
Simple interest: it’s interest earned solely on the initial deposit amount, paid out at the same fixed rate every period.
Compound interest: it increases earnings over time by calculating interest on both the initial deposits and the accumulating interest—allowing the money to grow at an exponentially faster rate.
The APY factors in the power of compounding. Compounding frequency can vary from daily to monthly to annually depending on the account terms.
Because compound interest accelerates savings growth so effectively, the higher the APY, the more earnings an account can generate over time. Online banks tend to offer more competitive yields around 4% APY versus the national average of only 0.46% (Source: What Is APY? Annual Percentage Yield Definition and How It Works) —a difference that can really add up through the compounding effect.
How to Calculate By APY Formula:
The Annual Percentage Yield formula is a useful tool for understanding how interest earnings growth works in bank accounts.
The APY formula is:
APY = (1 + r/n)^n - 1
Where:
r = the stated interest rate
n = number of compound periods per year
This formula combines the interest rate with the compounding frequency to project total earnings.
Let's walk through an example:
A $1,000 certificate of deposit (CD) offers a 3% interest rate paid at maturity in 24 months. The interest compounds annually.
1. First, we need to determine the number of compounding periods in a year. Since the interest is paid at maturity, which is after 2 years, there will be only one compounding period per year.
2. Next, we divide the annual interest rate by the number of compounding periods in a year. In this case, the annual interest rate is 3%, and the number of compounding periods is 1. So, we get 3%/1 = 0.03.
3. Now, we add 1 to the result from step 2: 1 + 0.03 = 1.03.
4. We then raise this result to the power of compound periods per year: (1.03)^1 = 1.03.
5. Subtract 1 from the result: 1.03 - 1 = 0.03.
6. Multiply this by 100 to convert it to a percentage: 0.03 x 100 = 3%. Therefore, the APY for a $1,000 CD with a 2-year maturity and a 3% interest rate paid at maturity is 3%.
So by factoring in compounding periods through this formula, we can calculate APY based on any interest rate.
Understanding Variable vs Fixed APY
Bank deposit accounts typically offer either a variable or fixed annual percentage yield (APY).
With a variable APY, the interest rate fluctuates over time based on macroeconomic trends and benchmark rate changes from the Federal Reserve. So the actual earnings percentage may shift up and down.
Conversely, a fixed APY locks in a guaranteed rate of return that does not change for the specified term. This provides certainty on returns but reduces flexibility.
Most standard checking, savings, and money market accounts have variable rates reactive to market rate moves. This allows for interest earned to respond to rising-rate environments. Meanwhile, fixed APY terms of 6, 12 or 18 months are more commonly associated with certificates of deposit (CDs) or special promotional offers.
For instance, a bank may offer 5% APY on the first $500 in a new checking account, reverting balances above that threshold to a baseline 1% variable APY. This type of tiered hybrid rate can incentivize initial deposits.
So whether variable or fixed fits needs best depends on individual timeframe constraints, rate outlooks, and earnings consistency preferences. Evaluating tradeoffs can optimize account structures.
APY vs. APR
While APY (Annual Percentage Yield) measures potential earnings on bank account savings, APR (Annual Percentage Rate) indicates the all-in costs of borrowing money annually.
Essentially, APY and APR are two sides of the same coin - but with opposite implications.
When shopping lending products like mortgages, auto loans or credit cards, the advertised rate only reveals part of the picture. The APR factors in the total outlays over a year - including the interest expenses plus any fees or points charged by the lender upfront.
For example, a mortgage may be listed at a 3% interest rate. But after including $2,000 in origination fees, the APR could be closer to 3.5%.
So while a high APY signals greater returns on deposited savings, a lower APR signifies more affordable loan terms overall. By understanding how to compare both metrics, consumers can better assess earnings potential versus total borrowing costs when managing finances and navigating major purchasing decisions.
Seek higher APYs when saving money, and lower APRs when financing over time. Keeping an eye on both can lead to optimized cash flow.
How Does Compound Interest Work?
Compounding happens at defined periods, usually daily or monthly. More frequent compounding (daily) results in higher returns than less frequent (monthly).
Though the difference seems negligible in the short-term, small gains compound over time. When opening savings vehicles, maximizing the Annual Percentage Yield (APY) makes balances grow faster through compound growth.
You can project earnings with a compound interest calculator using:
The initial deposit
Expected monthly contributions
The account’s APY and compounding frequency
Total timeframe for money to grow
For example, a $1,000 initial deposit with $100 monthly contributions, 0.50% APY compounding daily, would yield $2,208 after one year ($1,000 initial + $1,200 contributions + $8 interest). After 20 years of the same monthly deposits and daily compounding at the same rate, the account balance would reach $26,351.
What APY Means for Bank Accounts
Several common deposit account types provide interest earnings, including:
Traditional and high-yield savings accounts
Money market accounts
Certificates of deposit (CDs)
The Annual Percentage Yields on these vehicles can diverge widely depending on whether held at an established bank, online bank, or credit union.
Generally, online banks tend to offer higher published rates because they have lower overhead costs.
Across account types, higher APYs directly translate to faster compound growth and greater returns on your principal deposits over time. So when opening any new interest-bearing account, be sure to evaluate the APY alongside other factors like deposit minimums, fees, accessibility, etc. Maximizing APYs within your chosen product category and institution can better optimize savings potential.
Even an extra 1% APY on large deposits can make a sizable difference over ensuing years thanks to compounding interest doing the heavy lifting.
FAQ for Annual Percentage Yield (APY)
1. How Can APY Help an Investor?
When judging any investment, whether a certificate of deposit, a share of stock, or a government bond, one should consider its rate of return. The annual percentage yield (APY) provides a standardized measurement of return.
By converting various returns into APY figures, investors can assess those returns on the same terms to make better-informed decisions when choosing where to put their money. The APY gives investors a key piece of data to evaluate investments more consistently.
2. What is the difference between APY and interest rate?
The interest rate is the annualized rate paid on the account, such as 0.40%. APY factors in the effect of compounding interest over a year. So while the nominal rates may sometimes be the same, APY gives a more accurate picture of total earnings for the saver over time. Knowing both allows for an informed comparison when choosing an account.
3. Is APY paid monthly?
The interest accrued on your deposit may be compounded either daily, monthly, or yearly depending on the type of deposit account that you have opened with the financial institution.
This means that the accumulated interest on your principal amount will be added to your account at regular intervals based on the compounding frequency selected by the bank. Therefore, it is important to carefully review and compare the interest rate and compounding options of different deposit accounts offered by the bank before making a decision.