Takeaways
- APY is the true rate of return earned on money in one year with compounding interest.
- The more frequently interest compounds, the higher the Annual Percentage Yield.
- APY describes returns generated on savings, checking, or certificates of deposits.
- Compounding interest is added to the balance of your investment at precise points.
- APY considers both the interest earned to date and the initial principal investment.
What is Interest?
Interest is the cost of borrowing money. When a lender lets you borrow money, you will likely pay interest. Conversely, when you lend money, you earn interest. For investors, this is called interest income.
Interest is expressed as a percentage rate over one year, known as the annual interest rate. In a savings account, for example, the bank pays you interest for using your money to make loans to others. The interest rate you earn on your savings can vary greatly depending on the bank, the type of account, and the overall economic environment.
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There are two main types of interest: simple interest and compound interest. Knowing the difference between the two is critical to understanding how Annual Percentage Yield works.
- Simple Interest: You earn the same amount of interest on the principal amount each period. There is no compounding effect.
- Compound Interest: You earn interest on the principal amount plus the accumulated interest to date. Compounding interest is much more powerful than simple interest and can generate higher returns for investors.
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What Does APY Mean?
Annual Percentage Yield, or APY, reflects the real rate of interest earned in interest-bearing accounts, factoring in the compounding effect of interest. The APY is typically defined as the interest earned in one year, expressed as a percentage1. Unlike simple interest rates, APY gives a more comprehensive picture of potential earnings with financial products, including savings accounts, checking accounts, and certificates of deposit.
APY is a helpful calculation because it includes compounding frequency, which shows the actual financial impact over a year. By considering the effects of interest compounded daily, monthly, or quarterly, APY offers a more holistic and accurate understanding of your investment's growth. APY is a vital comparator for analyzing financial products and making informed financial decisions.
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For high-yield savings accounts, the higher the APY, the more interest you earn on your savings balance and accumulated interest. Many online banks offer high APYs, which can help you increase your savings and reach your financial goals quickly. Here are Smart Money’s picks of the best high-yield online savings accounts.
How to Calculate APY
The formula for calculating APY, according to the Consumer Financial Protection Bureau, or CFPB, is:
APY = 100 [(1 + Interest/Principal)(365/Days in term)−1]
Where:
- Principal = Amount of money deposits at the beginning of the account
- Interest = Total dollar amount of interest earned on the principal for the term
- Days in Term = Number of days in the term account
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For instance, let’s say you deposit $15,000 into your savings account at the beginning of the year on January 1st, and you keep those funds in your account the whole year. At the end of the year, your bank pays you $135 in interest income for a 365-day year. Your APY would be approximately 9.00% (not bad).
Because APY considers compounding interest, the higher the APY and the more frequent the compounding periods (daily, monthly, quarterly, annually), the faster your investment will grow.
APR vs. APY: What’s the Difference?
Knowing the difference between APR and APY is critical for making informed financial decisions. Here is a summary of the differences:
Annual Percentage Rate (APR): APR refers to the annual cost of a loan to a borrower, excluding the impact of compounding. APR uses the simple interest method. APR consists of interest and fees (such as maintenance or annual fees). The lower the APY, the lower the interest you will pay over the life of your loan. APY must be displayed prominently for credit cards, mortgages, car loans, personal loans, and other credit accounts. When you get a new loan or credit account, you must understand the APR.
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Annual Percentage Yield (APY): APY is the annual rate of return an investor makes from interest-bearing accounts. These interest-bearing accounts include high-yielding savings accounts, checking accounts, and certificates of deposit (CDs). APY uses compound interest and not simple interest (like APR). Additionally, APY does not include fees like APR. Investors use APY as a comprehensive comparative indicator because it reflects the total interest accrued over a year with compounding interest considered. This allows you to compare your rate of return between different options, allowing you to align your risk appetite, investment horizon, and financial goals.
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How Compound Interest Works
Compound interest is interest earned on your initial principal plus the interest accumulated over previous periods. Each time interest is calculated and added to the account balance, the larger balance earns more interest in subsequent periods.
For example, if you have a high-yield savings account with a principal of $1,000 and an APY of 5%, compounded annually, the first year's interest would be $50, making the new balance $1,050. In the second year, interest is calculated on the new balance of $1,050 (principal plus accumulated interest), resulting in $52.50 of interest. The new balance at the end of the second year would be $1,102.50.
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Over time, compound interest can significantly increase the growth of your investments. That is why financial experts advocate reinvesting interest income rather than withdrawing those funds. This can be particularly useful in your emergency fund or slush fund because you can let these balances increase over time and not have to lift a finger. All you need to do is ensure these funds are in a high-yielding online savings account.
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Is APY Variable?
APY can be either fixed or variable, depending on the financial product. With a fixed APY, the interest rate stays the same for a specified period, ensuring a predictable return on your investment.
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In contrast, a variable APY can change over time because it is pegged to certain economic indicators or index rates, like the prime rate. This variability means the total interest earned on a savings account can fluctuate. Determining whether you want a fixed or variable APY is a portfolio decision, and you should consider all your investments.
Smart Summary
When you are trying to grow your net worth or increase your income, understanding APY is important. Because APY determines how much interest income you will make on interest-bearing accounts and investments, it is an essential variable when comparing investment opportunities. Regularly checking on the APY of your investments is a smart money move and should align with your long-term financial goals.
(1) Consumer Financial Protection Bureau. Annual Percentage Yield Calculation. Last Accessed November 20, 2023.
