APY stands for annual percentage yield. When opening savings, checking, or investment accounts, you may see your financial institution list an APY. Understanding your APY can help you determine how your money will grow over a year and make smart decisions about your cash flow management.
What is an annual percentage yield?
Annual percentage yield (APY) is the percentage of growth or “rate of return” you earn on an investment over one year. APY grows exponentially through compounding interest. As you earn interest, it’s added to the principal amount. With each interest period, an account’s balance will increase, and the new balance earns more interest. The higher the APY, the faster the money in the account will grow. Financial institutions will list the APY for any account that accrues compounding interest.
How does an annual percentage yield work?
APY accounts for several factors that demonstrate an investment’s earning potential. First, it calculates the interest rate for an account. This is the simple interest that will accrue on your principal amount. Then it takes into account compounding interest and the frequency at which interest will compound. Together, these factors indicate how your principal will grow in a year.
How does compounding interest work?
Compounding interest refers to interest collected on a deposit, plus interest collected on any earnings. Simple interest rates, like annual percentage rates (APR), only collect interest on the original deposit amount. But with compounding interest, the accrued interest is added to the principal amount. The principal will continue to grow exponentially as more interest is added.
How to calculate annual percentage yield with the APY formula
The APY formula divides an interest rate by the number of periods an investment compounds in a year and adds 1. The formula then expands that number by the same investment-compound period. The formula then subtracts that number by one. The formula follows:
APY = (1 + r/n)n – 1
R is the interest rate as a decimal (i.e., 0.11% or 0.0011). N is the number of periods the investment compounds in a year. If an investment accrues monthly, for example, n is 12. Here’s an example of how to calculate APY.
Say you deposit $100,000 into an account with a .05% annual interest rate that compounds monthly. Let’s assume you do not add or remove anything from the account throughout the year. Using the APY formula, you can assess the rate of growth for a year:
(1 + 0.0005/12)12 – 1 = 0.0005001
To determine how this growth translates into dollars, you’ll need to take a couple of extra steps. Multiply your APY result (0.0005001) with your starting principal amount ($100,000). Then add that number ($50.01) to your starting principal ($100,000) to find your account’s final total. In this case, your account will grow from $100,000 to $100,050.01 in a year. The formula follows:
(APY x principal) + principal = total after a year
What is a good APY?
Generally, you can consider an APY higher than the average rate for that account type a good APY.
|Account Type||Average annual percentage yield|
|Interest-bearing checking account||0.04%|
|12-month certificate of deposit (CD)||0.26%|
Average rates from the week of June 1, 2020. Source: Federal Deposit Insurance Corporation (FDIC)
Financial institutions may offer different rates on the same type of account. The APY offered can also depend on the account’s minimum balance obligation, so it pays to compare your options. The higher the APY listed on an account, the better. Some online savings accounts may have higher APYs, reports CNN Money. These online banks can offset the cost of running a physical bank in exchange for a higher APY.
Is APY variable?
An account using APY might be variable, depending on your bank’s terms and conditions. A variable interest rate is a rate that adjusts to market conditions. Other names for variable interest rates include “adjusted” or “floating” rates. If a financial institution offers variable APY, then the APY may increase or decrease according to national averages.
Typically, the Federal Reserve uses the Federal Funds Rate to help banks determine an appropriate APY for customers. The Federal Reserve sets a target range for rates, and banks may adjust their rates monthly or annually.
APY versus interest rate
APY is a type of interest rate that compounds interest. But not all interest rates use APY. Typically, an interest rate is a percentage banks pay you to hold your deposit in an account that they provide. Simple interest is a common interest rate. Interest rates may also appear on loans, credit cards, and other investment accounts. Most deposit accounts that earn interest, such as checking or savings accounts, use APY.
APY versus APR
An annual percentage rate is another type of annualized interest rate. While APY is often used to help you understand how much interest you can earn on your money, APR indicates how much it costs to borrow funds annually.
Unlike APY, APR does not compound interest. One of the most common applications of APR is expressing credit card interest rates or loan interest rates.
You can calculate APR by multiplying the interest rate by the number of periods in a year. The formula follows:
APR = interest rate x number of periods per year
Watching your money grow
By calculating your APY, you can better understand how your money grows over time. Even if growth starts small, it can add up over time through compounding interest. APY can help you get the most out of your savings, investment, or interest-bearing accounts.
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