In an era marked by an abundance of savings and financial products, understanding the intricacies of how each type of interest-earning account works is more important than ever. Doing so will allow you to identify opportunities to grow your wealth. However, before venturing into what those products are and how they can work for you, it’s critical to understand the fundamentals that many of them share. One of the most instrumental features of those products is annual percentage yield (APY).
APY may just seem like another acronym in the sea of financial jargon, but for committed savers, it’s one of the most important. It plays a pivotal role in determining the growth and profitability of your savings and investments, and understanding how it works is essential to making more informed financial decisions.
Read on to learn about what APY is, how it works and how it can help you grow your savings and investments.
What is annual percentage yield (APY)?
Annual percentage yield, or APY, is a measure that extends beyond simple interest rates and involves the dynamics of compound interest. It serves as a way to calculate the true potential of your savings or investment accounts over a given period of time.
APY is the total interest you earn on money in an account over an entire year, represented as a percentage. While an annual interest rate is a component of APY, it isn’t the sole determinant of how APY works. To better understand that, you need to learn how compound interest works.
Albert Einstein is credited as once musing, “Compound interest is the eighth wonder of the world. He who understands it earns it…he who doesn’t…pays it.” While simple interest allows you to earn the same amount of interest over a given period, compound interest accrues interest on both the money in the account and the interest previously earned. This allows your funds to grow faster.
The amount of interest you earn depends on both the interest rate and the number of compounding periods in a year. Interest can be compounded daily, monthly, quarterly or annually depending on the type of account in which the funds are held. After each compounding period, your account balance increases — so subsequent interest paid will also increase. If an account compounds annually, it will earn less interest than an account that compounds monthly. APY factors this into the equation.
How annual percentage yield works
APY standardizes a rate of return by using a formula that combines the interest rate and the number of times interest compounds in a given year. This produces the real rate of return that you will see your account reflect at the end of 12 months.
APY formula and APY calculators
The formula used to determine APY is:
- APY = (1 + r ⁄ n)n – 1
In this equation, r = the interest rate as a decimal (e.g., 5% is 0.05) and n = the number of compounding periods in the calendar year.
If you’re not comfortable with calculating it yourself or if you already know your APY, you can use free APY and compound interest calculators available online to determine how much your accounts will be worth in one year’s time. These only require you to plug in the figures, and they will do the calculations for you.
Example of APY
The following example demonstrates the power of compounding interest compared to simple interest. If you put $1,000 into an account with a 5% interest rate, at the end of 10 years, you would have $1,500:
- 1,000 (principal) x 0.05 (5% interest rate) x 10 (years) = 1,500
After one year, your principal amount would account for 67% of the balance and interest would account for the remaining 33%. However, if you put the same $1,000 into an account with a 5% interest rate with interest that compounds monthly, after 10 years, you would have $1,647.01 with an APY of 5.12%:
- 5.12% = (1 + 0.05 ⁄12)12 – 1
The longer the money accrues interest and the more the compounding periods it experiences, the larger the balance will grow.
Types of annual percentage yield
There are two types of annual percentage yield: variable APY and fixed APY. The following section details both.
A variable APY has an interest rate that can fluctuate over time. For example, a bank or credit union can adjust the APY it offers for accounts based on how the economy is performing or if the Federal Reserve is increasing or decreasing its benchmark interest rate, the effective federal funds rate.
Depending on the type of bank account or credit union account you have, you’re probably already earning a variable APY with a defined frequency of compounding interest. Almost all of the best savings accounts have a variable APY, while some checking accounts do, too.
In addition to traditional savings and checking accounts, financial products like money market accounts and high-yield savings accounts also offer variable APYs. Like most deposit accounts, the best money market accounts and the best high-yield savings accounts are offered by FDIC member institutions, which means your money is protected up to $250,000 per depositor.
As its name suggests, a fixed APY provides a predetermined and unchanging interest rate that is guaranteed by a bank, credit union or financial institution for an entire term. With a fixed rate APY, the interest rate will not fluctuate regardless of economic conditions or changes to the benchmark interest rate by the Federal Reserve.
Fixed APYs are commonly seen with certificates of deposit (CDs). CDs provide a predictable return with an APY that is generally higher than money market accounts or high-yield savings accounts because your funds are committed to the issuer’s terms. Common CD terms range from three months, six months and a year, to two, three and five years. If you withdraw your money before the maturity date, you can face early-withdrawal penalties, which typically entail sacrificing some accrued interest.
Like money markets and high-yield savings accounts, the best CDs are FDIC-insured.
What is annual percentage yield FAQs
What is the difference between APY and an interest rate?
Is APY the same as annual percentage rate (APR)?
What is a good APY?
Additionally, an account's APY is influenced by both the type of investment or savings products as well as the type of institution offering them. Regular savings and checking accounts tend to offer the lowest APYs, but credit unions typically offer higher APYs than brick-and-mortar banks. Money market and high-yield savings accounts have higher APYs than traditional savings and checking accounts, but generally fall short of those offered by CDs. CDs tend to offer the highest APYs since your funds are inaccessible without penalty until they mature.
Summary of Money's What Is Annual Percentage Rate (APY)?
Understanding APY can help you choose a financial instrument that fits your savings or investing goals. APY is determined by factoring for the interest rate and the number of compounding periods in a year. The interest rates used to determine APY can be either variable or fixed depending on the type of account. APY plays a pivotal role in determining the growth and profitability of your savings and investments, and understanding how it works is essential to making more informed personal finance decisions.