APY is an acronym and stands for annual percentage yield. It measures the amount of interest paid on banking deposits, such as savings accounts and certificates of deposit, that are held in an account for a full year. The metric offers a more accurate depiction of income potential on interest-bearing accounts that accrue interest on daily, monthly or quarterly compounding periods. Although understanding APY is important for simple financial literacy, it can actually hold major ramifications when people start making important financial decisions about allocating savings.
APY is a popular metric that allows holders of deposit accounts to accurately understand the amount of interest income generated by their account. It is only applicable if the compounding periods on the account are shorter than one year; monthly and quarterly periods are both common.
Each month, the interest paid in the prior period is added to the account, and interest is paid on these new funds as well, resulting in a compounding effect. This can substantially increase the income potential of simple interest rates.
APY includes both the interest rate and the impact of compounding interest. To calculate APY, the following steps are taken:
- Step 1: The simple annual interest rate is divided by the number of compounding periods in each year.
- Step 2: The resulting number is then added to one.
- Step 3: The number is raised to the power of the number of compounding periods.
- Step 4: One is then subtracted from the number to provide the APY.
It follows the equation: APY = (1 + (periodic rate ÷ number of times compounded)) ^ (the number of periods in a year) – 1
The number of compounding periods is usually one per month, although daily and quarterly periods are also used for some accounts, such as certificates of deposit.
For example, consider a savings account paying a 1.20% interest rate with interest paid on a monthly basis. Each month, this account will pay 0.10% interest on the balance, and the new funds will compound. The resulting APY will be 1.21%, which is somewhat higher than the simple interest rate on the account. An account with $50,000 at the above rate will grow to $50,600 if interest is only applied once annually, but the same amount will grow to $50,603 if the compounding period is monthly.
At low rates or low account balances, the short-term discrepancies between APY and annual interest can be modest. But these differences are much more substantial with higher account balances, higher rates or longer time periods.
More on Savings Accounts: Earning High-Yield Profits
APY can be confused with annual percentage rate, but the two metrics are easily distinguished by several factors. APR is a much more frequently searched term and a measurement with which consumers are more familiar.
APR is a measurement of the total cost of debt, expressed as an annual percentage. Its calculation includes interest as well as fees, closing costs and other related expenses. This figure is disclosed by lenders so that borrowers understand the actual costs of using a debt instrument. APR is so important in the analysis of debt that the government requires lending institutions to disclose APR whenever rates are advertised.
APY is also a representation of interest. It is disclosed by financial institutions to holders of deposit accounts so that account holders can understand the interest an account will accrue. From the perspective of a consumer, it is the virtual opposite of APR, as it measures cash inflows rather than outflows.
Learn More: Credit Card Rates
Capital allocation can involve an intimidating and confusing set of decisions for most people, but it is an essential part of any financial plan, especially as savings begin to accumulate later in life. It’s important to weigh risk, volatility, rate of return and opportunity cost when directing funds to a financial product. APY is essential when assessing the rate of return and opportunity cost of allocating to a savings account or CD relative to another vehicle.
Retirees who live off of the income generated by interest on accumulated assets must understand how much cash flow a deposit account could generate to meet their basic needs and lifestyles. If APY is insufficient to cover those costs, an alternative option should be considered. Someone carrying debt might want to take funds from a deposit account to retire the loans, but it might not be the most prudent decision if the APY on that account exceeds the interest rate on the loan. The calculation of APY would be even more meaningful in this case if the loan interest rate happened to fall between APR and APY.
More From GOBankingRates
- The Easy Way To Grow Your Money by 3% While Doing (Almost) Nothing
- Best Balance Transfer Credit Cards
- Best Online Banks of 2020
- Credit Card Companies That Offer High-Yield Savings Accounts
This article has been updated with additional reporting since its original publication.