What Is APY And How Is It Calculated?
Sarah Sharkey4-minute read
May 09, 2022
If you’re focused on saving money, you might find yourself wondering about APY when exploring your account options. A higher annual percentage yield (APY) can help you build up your savings faster.
Let’s take a deep dive into what APY is.
What Does APY Stand For?
APY, short for annual percentage yield, is a figure that shows how much an interest-bearing account will earn based on compound interest costs. In simple terms, it tells you the rate that will be earned on an investment over the course of a year, factoring in the effects of compound interest.
Ultimately, comparing APYs across savings accounts, checking accounts, and other financial investments can help you find the more profitable place to save your money.
How Does APY Work?
APY is the true amount that you’ll earn from interest-bearing accounts like savings or money market accounts, and select financial investments like CDs, bonds or bond funds.
APY effectively calculates how much money will be earned or charged when interest is added to a principal sum invested or borrowed, and these sums compound. At odds with simple interest-based calculations, APY takes into account the effects of compounding interest (which is calculated periodically) over time, rather than using simple interest to gauge your investment’s potential. Ultimately, APY provides a more accurate snapshot of how much you stand to gain.
A higher APY will result in a faster-growing investment.
What Is A Good APY?
As a general rule of thumb for investments or debts, the higher the APY on a savings account, the better off you’ll ultimately be.
Whether an APY is considered good depends on the account type. For example, the national average APY on savings accounts is rather low at around 0.06% as of April 2022. However, it is entirely possible to find savings accounts with higher APYs.
But if searching for a 24-month CD, you should raise your APY expectations. The national APY average for 24-month CDs is 0.22%. Savvy savers can likely find a higher APY available through a nontraditional bank.
As a saver, you should compare the available APYs for your preferred product type. With a little bit of legwork, you will likely find a reasonably attractive APY.
Annual Percentage Yield Formula: How To Calculate APY
APY is calculated using a mathematical equation that factors in compound interest and growth. This formula is as follows:
APY = (1 + (r/n))^n - 1
Under this equation, “r” is the stated annual interest rate, and “n” is the number of compounding periods each year.
While it’s possible to compute these numbers on a calculator, you may instead wish to utilize a spreadsheet to save time and effort and determine how yields vary with quarterly compounding vs. monthly compounding.
For example, in the case of a $1,000 deposit made to an account that pays 5% in simple interest once annually, you’d earn $50 at the end of the year. If the account provider instead paid interest monthly, you’d finish the year with $51.16 in additional funds. While the difference in sums may look small at first, or in any given brief period, it’s important to remember that these numbers can add up and grow significantly over an extended period of time.
Below we work out the calculations assuming a $1,000 deposit and a 5% interest rate either compounding annually or monthly. To see how much you’d end up with at the end of the year including interest, take the APYs below, multiple them by $1,000 and then add that number to your original $1,000 deposit.
APY = (1 + (r/n))^n – 1
APY = (1 + (.05/1)^1 – 1
APY = 0.05
APY = (1 + (r/n))^n – 1
APY = (1 + (.05/12))12 – 1
APY = 0.0516
When weighing savings instruments, it’s also important to compare APYs to know how much you stand to earn, and which offer the most favorable upsides.
Note that interest compounding typically occurs over a set period, such as daily or monthly. The more frequently that interest is compounded in the case of an investment, the more money you’ll earn.
The Difference Between APY And APR
Essentially, the difference between APY and APR boils down to how much you’ll earn vs. how much you’ll pay. APY represents how much a financial institution will pay you. But APR represents how much you’ll pay a lender when taking out a loan.
An annual percentage rate (APR) is related to the concept of APY, but it uses simple interest rate to convey how much banks charge per year for loans, credit cards, and other sums borrowed. Financial lenders are required to disclose this information, which calculates the cost of most types of consumer loans (which are based on simple interest), under the Truth in Lending Act (TILA). However, APR does not factor in compounding interest.
On the flip side, APY – required to be disclosed by the Truth in Savings Act – calculates what is earned by compounding interest on interest-bearing assets like savings accounts, certificates of deposit (CDs) or bonds.
How does APY work with consumer loans?
Most consumer loans, excluding ARMs and credit cards, use simple interest to calculate the borrower’s monthly payments, which also typically will not charge over the term of the loan. Loan providers routinely disclose the APR associated with these financial products to maintain regulatory compliance and provide customers with a baseline metric through which to compare offers, taking all fees into account.
How does APY work with credit card debt?
Too many variables come into play with credit card debt to reduce APY to a simple formula. These factors include whether customers carry a current balance, what percentage of the bill the cardholder pays each month, and what types of charges the holder has made. For example, cash advances usually begin compounding interest immediately, while repaying the full cost of charges on purchases made each month causes the cardholder to incur no additional interest payments.
How is interest calculated for investments?
The interest rate offered by an investment or loan product generally reflects the overall riskiness of a transaction. By way of illustration, savings bonds that are issued and backed by the U.S. government are considered among the least risky of all financial investments, and therefore pay the smallest yields. As a counterpoint, bonds issued by corporations or municipal governments, because they’re considered to be riskier investments, pay more interest to compensate potential investors for taking on this risk.
The Bottom Line
Given enough time, a high APY can help you grow your savings substantially. If you are considering different investment products, comparing APYs can help you make the best decision for your finances.
Want to brush up on other personal finance basics? Explore our other resources today.
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