What Is APY? How Annual Percentage Yield Works

Written by Jennifer PachecoUpdated: 21st Nov 2021
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Annual percentage yield, also known as APY, is the rate of return on a particular investment. In simpler terms, the APY refers to how much your investment grows in a year numerically.

An annual percentage yield is much different than a typical interest rate. Why? Because the APY always factors in compounding interest, and a regular interest rate does not.

The key takeaway is that an APY is the easiest and most clear and concise way of seeing how much your money will grow over a certain amount of time.

What Is Annual Percentage Yield (APY)?

One of the biggest misconceptions in the finance world is that APY and APR are similar. They’re far from alike.

You see, APR refers to an annual interest rate without compounding interest, and an APY refers to an annual interest rate with compounding interest. If you’re investing or borrowing, compounding interest can really make a difference.

You’ll want to lean towards investing or borrowing when the APY is higher, which means you’ll want to look for places that offer frequent compounding periods.

Every time a compounding period comes around, you’ll earn interest on both the principal and the simple interest you’ve already earned. It’s like a double bonus!

>> More: See the Best Online Bank Accounts

How Does APY Work?

Once you get the hang of it, understanding APY is very easy. Here’s an example:

  • If you were to take $1,000 cash and deposit it into an APY savings account that has a 5% interest rate annually, you’d make $1,050 at the end of the year. But with APY, the bank you’re using will calculate and pay interest every month on your account. If you end the year with earning $1,050 naturally, the bank will then add on the interest it pays every month, leaving you with ~$1,051.16 at the end of the year.

Such a small addition may not matter initially, but after many years or larger deposits are made, the acquired additional interest can really make a difference.

How Is APY Calculated?

A simple formula is used to calculate APY. That formula is:

APY = (1 + r/n)n + 1

If you analyze this formula, you’ll find that the r is where the interest rate you earn on a deposit account goes. The n stands for the number of compounding periods there are in a year.

Once you plug those numbers in, you can do the calculations through an automatic spreadsheet or APY calculator and see how much money you’ll earn on average at the end of each year.

Annual Percentage Yield Example

Outside of the example presented above, here is another.

If you take this formula: APY = (1 + r/n)n + 1 and apply it to a 5% interest rate with 12 compounding periods throughout the year, you’ll see a plugged-in formula like this: (1+0.5/12)^12-1= 5.116 percent.

Again, any calculations can be done through a spreadsheet or APY calculator. For more examples, just head over to the internet and search “Annual Percentage Yield Example.”

How Compound Interest Works

To fully understand how compounding interest works, you first need to know whether the compound periods are done daily, monthly, quarterly, or yearly.

Compounding interest generally only leaves you with small difference amounts at the end of the year – unless you’re dealing with large deposit amounts.

Will an APY make an exaggerated difference? Not really. Especially when you’re comparing daily and monthly compounding periods.

For example, if you have $100,000 in an account and you earn 0.50% APY, at the end of the year, you’ll only have a $0.10 approximate differential if your account compounds daily instead of monthly.

>> More: How Do Interest Rates Work?

How to Find the Best APY

If your primary goal is to grow your savings account over a long period, considering different institutions for their APY rate would be a good idea.

Honestly, all it takes is a little research into banks and bank accounts, and you’ll be sure to find the right APY rate for you in no time.

To get a head start, I’ll tell you this: A lot of online banks offer higher APYs. Why? Because they have a much lower overhead cost.

Credit unions can be competitive with their APYs. Brick-and-mortar banks are the lowest on the totem pole.

Just remember, when comparing APYs, look into what kind of account you’ll be earning interest on.

Also, keep in mind whether the APY is flat or tiered. If you have any other questions, reach out to your preferred financial institution to obtain more information.

Differences Between APY and APR

APY associates itself with compounding interest and represents the actual rate of return on investment, almost down to the exact penny.

APR often has additional fees and costs associated with the investment, and it does not compound the interest earned. APR is only the simple interest rate earned at the end of each year.

>> More: Differences Between APY and APR

What Is the Difference Between APY and Interest Rate?

An interest rate is the rate of interest earned on whatever account you have with your financial institution. Savings accounts often carry interest rates.

APYs may be the exact same as the interest rate given, but that’s not always the case.

In any case, an interest rate is simple – one flat rate that is earned. Whereas an APY is compounded, eventually earning your more on your investment at the end of the year.

Is APY Paid Monthly?

That depends on the financial institution you are dealing with and the account you have there.

Some accounts can compound monthly, whereas others can compound daily. Ask your bank or credit union of choice for further information.

Is APY Variable?

If you have a savings account, the APY rate is variable, meaning the rate of return can increase or decrease depending on how well the market is doing.

If you have a certificate of deposit, the APY generally stays the same rate throughout the term you’ve signed up for.

If you purchase additional CDs in the future, they may have an entirely different APY rate than previously purchased CDs.

>> More: Best CD Rates

What Is a Good APY?

The national average for an APY rate is 0.06%, but higher rates can be found if you’re willing to put effort into your research. As stated before, online banks offer the best APY rates, sometimes up to 0.45%.

Bottom Line: What Is APY?

Like I said before, once you get the hang of how an APY works, it’ll be easy to decipher where to go to get the best bang for your buck.

If you want to get the most from your high-yield savings account, just put in some time and find the best financial institution and account system for you. Considering when the APY is calculated may help, too.

Take into account if it’s daily, monthly, quarterly, or yearly, and take it from there. The differences can technically add up over time, especially if you’re making large deposits.

If a bank offers too low of an APR, ditch it and move on to the next one. There is no need to keep your money in one place when you could be earning much more over the years.

Jennifer Pacheco

Jennifer Pacheco attended the University of Dartmouth, Massachusetts where she earned her degree in English Writing & Editorial Work. She is a seasoned personal finance writer with over 5 years of professional work under her belt, and supplies easy-to-read information that’s educational, engaging, and conversational to help you make the most of your money.