Annual percentage yield is the effective annual return rate with the effect of compounding interest taken into account. In other words, APY refers to how much money you earn from a deposit over the course of a calendar year.
APY standardizes each rate of return by restating it over one year and tweaking it to include compounding period. Keep reading to learn why APY is important to understand if you want to know the exact amount of interest you’re paying or earning.
What Is APY?
APY is the interest rate that’s used to calculate the interest rate paid in a period. Because APY considers compounding, it accounts for the interest you pay or earn on the interest you accrue.
How Do You Calculate APY?
To understand how APY is calculated, take a look at an example. Say you put $1,000 in a CD account. Here’s how to calculate the APY:
APY = (1 + (periodic rate ÷ number of times compounded)) ^ (the number of periods in a year) – 1.
If the CD’s interest rate is 1.5 percent and compounded annually, the calculation would be:
((1 + (0.0150 ÷ 1))^ 1) -1 = .0150 or 1.50% APY
So after one year you’d have $1,015.00.
If the CD’s interest is compounded daily at same 1.5 percent rate, the calculation would be:
((1 + (0.0150 ÷ 365)) ^ 365) -1 = .0151 or 1.151% APY
So after one year of daily compounded interest, you’d have $1,015.11.
See More: What Is Compound Interest?
What’s the Difference Between APR and APY?
Whether you’re applying for a credit card or opening a savings account, you should know the difference between APR and APY. Most credit cards charge APR. This is sometimes referred to as a nominal interest rate, or the rate quoted based on an annual period. The APY is also known as the effective rate.
APR is different from annual percentage yield in that APY factors in the effect of compounding. When you carry a balance on your credit card, you might pay more than the actual APR because you are paying interest on top of interest. Although the amount might not be huge, you’ll be paying more in interest than the simple APR, because interest will be added to your balance each month.
Learn More: What Is APR?
How Does the FDIC Define APY?
The FDIC defines APY as the total amount of interest paid on an account based on the interest rate and the frequency of compounding. APY can be applied to deposit accounts, usually savings, but also some interest-bearing checking accounts. In this case, APY is what the bank pays you. When referring to a savings or checking account, the APY is the amount of money you earn expressed as a percentage.
For example, if you were to deposit $5,000 into a savings account with a 1.00% APY, your balance would be $5,050.00 after one year. The second year you would earn money on the $5,050.00, so your new balance after a second year, if you did not deposit anything, would be $5,100.50.
When shopping for a credit card, consider all your options. Once you’re using the credit card, make every effort to keep balances low — or better yet, pay off your balance in full each month. If you have multiple credit cards, consider consolidating debt.