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APY (annual percentage yield)

APY is a key financial term it pays to understand. Here’s what it is and how it works.

What is APY (annual percentage yield)?

APY, a commonly used acronym for annual percentage yield, is the rate earned on an investment in a year, taking into account the effects of compounding interest. APY is calculated using this formula: APY= (1 + r/n )n – 1, where “r” is the stated annual interest rate and “n” is the number of compounding periods each year. APY is also sometimes called the effective annual rate, or EAR.

Deeper definition

When the APY is the same as the interest rate that is being paid on a person’s investment, he is earning simple interest. When the APY is higher than the interest rate, however, the interest is being compounded, which means he is earning interest on his accumulating interest.

People sometimes confuse APY with APR. APR refers to the annual interest rate without taking compounding interest into account. APY, on the other hand, does take into account the effects of compounding within a year. The difference between the two can have important implications for borrowers and investors.

When banks or other financial institutions are looking for clients for interest-bearing investments, such as money market accounts and certificates of deposit, it is in their best interests to promote their best APY, not their APR. APY is higher than APR, so it looks like a better investment for the client.

The more frequent the compounding periods, the higher the APY. Thus, people who save money in their bank accounts should check how often the money is compounded. Typically, daily or quarterly is better than annual compounding, but make sure to check the quoted APY for each option beforehand.

APY example

If an individual deposits $1,000 into a savings account that pays 5 percent interest annually, he will make $1,050 at the end of year.

However, the bank may calculate and pay interest every month, in which case he would end the year with $1,051.16. In the latter case, he would have earned an APY of more than 5 percent. The difference may not be huge, but after several years (or with larger deposits), the difference is significant. In this example, APY is calculated like this:

Annual percentage yield = (1+0.5/12)^12-1= 5.116 percent

APY can show investors exactly how much interest they will earn. With this information, they can compare options. They will be able to decide which bank is the best, and whether or not they want to go for a higher rate.

Use this calculator to see if you’re on track to meet your investment goal.

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