Annual Percentage Yield (APY) is the percentage reflecting the total amount of interest paid on an account based on the interest rate and frequency of compounding for a 365-day period. The APY formula is a valuable tool for helping to make financial projections, especially over longer time periods. Let’s learn how to calculate APY and what makes it so important.
What is APY?
If you’re considering opening a savings account, you may be wondering, “What is APY and how important is it?”
APY refers to the real rate of return you can expect from a deposit account in a year. It considers the effect of compounding interest, as well as how often interest is paid, to produce a more accurate projection of returns. Assuming there are no withdrawals from the account, this means accounting for how interest adds to the principal amount and progressively increases the rate of return.
Interest rates measure the return paid within an interest period, and simple interest accounts only pay interest on the original principal amount. Compound interest accounts, on the other hand, pay interest on the principal amount and any interest previously accrued, leading to an acceleration over time. So, an account with 1% interest that compounds annually earns less than the same account that compounds monthly. APY takes this into consideration.
Understanding the APY formula
APY uses a formula to combine the interest rate and the frequency that it’s applied. The formula is a valuable tool that can help you understand how your account’s APY will affect the money that’s in it. Let’s take a look:
APY = 100 [(1 + Interest/Principal)(365/Days in term) - 1]
For example, let’s take a look at a $1,000 12-month certificate of deposit which pays $30.00 in interest for 1 year. You would first divide your interest earned of $30.00 by the principal of $1,000 — resulting in 0.030 — and add 1. This results in 1.030. Next, you would divide 365 by the number of days in the term, in this case, 365, producing 1. We then multiply 1.030 by 1, resulting in 1.030. We subtract 1 to end up with 0.030. Finally, we multiply 100 x 0.030 to arrive at our APY of 3%.
The importance of compounding frequency and APY
While that was a lot of math, the purpose of the formula is to consider interest rates and how frequently they pay. The difference in returns between two accounts with identical interest rates can become significant when compounded at different frequencies.
This is because increasing frequencies raises the entire equation by a higher power. Longer time scales magnify this effect, and even small changes in APY can add up over time as you continue accruing interest on interest.
Why does APY matter?
Ignoring the effect of compounding may produce inaccurate expectations for important financial milestones. Deposits are evaluated based on their projected returns; APY standardizes the rate of return, and helps when making projections. Understanding what APY is and how it’s calculated, may help you improve your financial literacy and help you make more well-informed decisions about your finances.
The timelines for long-term financial goals are especially susceptible to the compounding effect. Discerning when your savings account will reach your savings goal, for example, can vary according to minor fluctuations in the rate of return. APY helps reduce some of the fog when forecasting future financial outcomes.
APY vs APR: What's the difference?
Annual percentage rate, or APR, is what it costs you each year to borrow money and represents the interest you owe. Like APY, the APR of borrowed money is designed to give you a clearer picture of what you will owe.
APY applies to savings accounts as well as Certificates of Deposit accounts, and is used to calculate how much you can expect to earn through interest over time. Essentially, APR is what you owe, APY is what you earn.
How to check for APY in your accounts
In accordance with regulations set forth by the Truth in Savings Act, all financial institutions make the APY and other information about fees and interest available when opening accounts for customers. Any documentation regarding account terms you may have retained from your account opening may contain the account APY. If you can’t find it, don’t know your interest rate or compounding frequency or prefer someone else does the math, your financial institution can likely assist you.
The important point to remember about APY is that it considers compound interest and its frequency to provide a clearer picture of earnings over time. Understanding APY is important for comparing different interest-bearing accounts. How APY impacts your money is vital to making accurate forecasts for your financial future.