If investing in CDs is on your agenda then it’s a good idea to make sure that you understand what APY is. Both APY and APR reflect the interest rate you will get on your CD. But APY is the precise measure of the interest you receive after 1 year, while APR is only an approximation.
What is an APY?
An APY is also known as the annual percentage yield and reflects the amount of interest earned for your CD. What makes the annual percentage yield different from standard interest earnings is that it reflects compound interest, which moves at a separate frequency than simple interest. Instead of simply adding interest at year-end as would occur with the APR, APY adds the interest up within the year in intervals predetermined when your certificate of deposit is purchased. For example, you may be investing in CDs that offer semi-annual compound interest. This means, instead of adding your interest at the end of the year, you would add it up mid-year. Next, you would take the amount of interest earned and add it to the principal amount (the amount you first deposited). For the second half of the year, you would then be earning interest on the principal amount, as well as the amount that was added to your principal in interest.
An Example of an APY Calculation
To give you a better idea of how APY works, let’s look at an example of it in comparison to the APR:
Example 1: Tim buys a CD for $1,000 with an APR of 5% and the interest compounds only once per year. His earnings for the year will reflect a 5% increase, giving him a total of $1,050 at year-end. In this case APY is also 5%, the same as APR.
Example 2: Tim buys a CD for $1,000 with an APR of 5% and semi-annual compounding interest. His interest would be added twice. This means, at mid-year, he would receive $25 in interest (reflecting 2.5% for half of the year) which would be added to his principal amount of $1,000. Then at year-end, another 2.5% would be added to his new principal of $1,025, giving him a year-end total of $1,050.625 or $1,050.63. This means his APY would be 5.06%. The APY was determined by taking the interest earned ($50.625) and dividing it by the principal amount of $1,000 ($50.625/$1,000) to make the APY (5.06%). In this case, APY and APR are different.
By learning how APY affects investing in CDs, you can make your investment experience that much more pleasurable – and profitable.
