Annual Percentage Yield (APY)
Definition:
The Annual Percentage Yield (APY) is the rate of return on an investment or savings account, taking into account the effect of compounding interest over a one-year period. APY reflects the real return on an investment or savings account by including how often interest is compounded (daily, monthly, quarterly, etc.).
Unlike the APR, which reflects the cost of borrowing, the APY shows how much interest will be earned on a deposit over the course of a year. The more frequently interest is compounded, the higher the APY will be, even if the nominal interest rate is the same.
Example:
If you deposit $10,000 in a savings account that offers an interest rate of 5% compounded monthly, the APY would be higher than 5% due to monthly compounding.
Principal (Deposit Amount): $10,000
Interest Rate: 5% annually
Compounding Frequency: Monthly
With monthly compounding, the APY will reflect the effect of earning interest on both the initial principal and the accumulated interest each month.
Formula to Calculate APY:
To calculate APY, you can use the following formula:
APY = (1 + (r / n))^n - 1
Where:
r = Nominal interest rate (annual interest rate as a decimal)
n = Number of compounding periods per year
For example, if the interest rate is 5% annually and interest is compounded monthly, the formula would look like this:
r = 0.05 (5% as a decimal)
n = 12 (monthly compounding)
Plugging the values into the formula:
APY = (1 + (0.05 / 12))^12 - 1
APY = (1 + 0.004167)^12 - 1
APY ≈ 0.0512 or 5.12%
So, the APY for a 5% interest rate compounded monthly would be approximately 5.12%.
Why APY is Important:
Accurate Representation of Returns: APY takes compounding into account, making it a better indicator of the true return on investment or savings accounts compared to just the nominal interest rate.
Comparison Tool for Savings Accounts: When comparing savings accounts, CDs, or other interest-bearing accounts, APY helps you understand how much you will actually earn over time, given the effect of compounding.
Investment Planning: APY helps investors make informed decisions about which accounts or investment vehicles will provide the highest return, taking into account different compounding schedules.
Key Takeaways:
APY shows the total return on an investment or deposit, factoring in compounding interest.
It is a better indicator of returns than just the interest rate, especially for accounts with frequent compounding.
APY is used primarily in savings accounts, CDs, and other interest-bearing investments, helping you compare the actual returns of different products.