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What Is the Annual Percentage Yield (APY)?

APY stands for annual percentage yield, which is the interest rate you earn on an investment or savings account over a year, including the interest earned on the interest. A higher APY means more money in your pocket. Comparing APYs at different banks can help you find the best return on your money.

Formula and Calculation of APY

APY standardizes the rate of return by showing the real percentage of growth earned through compound interest over one year. The formula for APY is:

APY=(1+nr )n−1

Where:

– \( r \) = Nominal interest rate

– \( n \) = Number of compounding periods per year

What APY Can Tell You

APY helps you compare the growth of different investments by showing the impact of compound interest. More frequent compounding leads to faster growth. For example, if a money market account and a bond both offer a 6% rate, the money market account with monthly compounding will grow faster.

Comparing APY vs. APR

APY includes the effects of compound interest, while APR (annual percentage rate) does not. APR is usually used for loans and includes interest and fees, but not compounding. It’s important to consider both when looking at investments or loans.

How Compound Interest Works

Compound interest means you earn interest on your interest. 

For example, if you invest $1,000 at 6% interest compounded monthly:

– After one month, you’ll earn $5 interest, making your total $1,005.

– The next month, you earn interest on $1,005, so you get $5.03 interest.

– The third month, you earn interest on $1,010.03, and so on.

This means your interest earns interest, and your investment grows faster.

Banks in the U.S. must include APY in their ads for interest-bearing accounts so customers know how much they can earn in a year.

Variable APY vs. Fixed APY

Savings and checking accounts can have either variable or fixed APY. Variable APY changes with the economy, while fixed APY stays the same.

Both have pros and cons. Fixed APY offers certainty, but variable APY might increase when the Federal Reserve raises rates. Most accounts have variable APY, but some promotional offers may have higher fixed APYs for a limited amount of deposits.

APY and Risk

Higher APYs usually come with higher risk or restrictions. For example:

  • Checking accounts have the lowest APY because they offer easy access to your money.
  • Savings accounts have higher APYs but are less accessible.
  • Certificates of deposit (CDs) offer the highest APYs because you can’t access the money without a penalty.

The Bottom Line

APY tells you the actual rate of return you’ll earn on an investment or savings account by including the effect of compound interest. It’s usually higher than simple interest because it considers the interest earned on interest.

FAQs

1. How is the annual percentage yield (APY) calculated?

APY is calculated by considering the interest rate and how often it compounds. It shows the true annual rate of return by including the effect of interest compounding throughout the year.

2. What does 5.00% APY mean?

A 5.00% APY means you will earn 5.00% interest over a year, including the interest on the interest. For example, if you deposit $1,000 in an account with a 5.00% APY, you will have about $1,050 at the end of the year, depending on how often the interest compounds.

3. What is a good APY percentage?

A good APY varies by account type and current economic conditions. Generally:
  • Traditional savings accounts: 0.50% to 2.00%
  • High-yield savings accounts: 2.00% to 5.00%
  • Certificates of Deposit (CDs): 2.00% to 4.00% for short-term, higher for long-term
  • Money Market accounts: 1.00% to 3.00% or more

    • A higher APY is better, but also consider fees, minimum balance requirements, and the bank's stability.