If you have a savings or investment account, you’ve likely heard the acronym APY. It’s short for annual percentage yield and signifies the interest rate you earn on either of these accounts over one year, factoring in compounding interest. Here’s what to know about APY, how it’s calculated, how it differs from APR and how to maximize your earning potential.
What is APY, and How Does It Work?
The annual percentage yield (APY) represents the effective annual return on a savings or investment account. It also considers compounding interest, meaning you can earn interest on both your initial deposit and the interest accumulated over time.
It is expressed as a percentage and paints a clearer picture of your investment’s true earning potential. Frequent compounding periods result in a higher APY.
How is APY Calculated?
The following formula is used to compute APY:
APY = (1 + r/n) ^ n -1
Components of APY Calculation
Below are the components of the APY equation:
- r = annual interest rate expressed as a decimal
- n = compounding frequency or number of compounding periods per year
Example Calculation of APY
To illustrate how the APY formula works, assume you open a savings account with a 6% annual interest rate that compounds monthly. Here’s how you’d compute the APY:
- Step 1: APY = (1 + 0.06/12)^12 – 1
- Step 2: APY = (1 + 0.005)^12 – 1
- Step 3: APY = 1.06168 – 1
- Step 4: APY = 0.06168 or 6.17%
In this case, your APY would be 6.17%, which is slightly higher than the 6% annual interest rate.
Is APY Different From APR?
The two terms sound similar but hold different meanings.
When to Use APY and When to Use APR
APY refers to the interest earned on accounts, but APR pertains to the costs of borrowing money minus the effects of compounding. The latter would be applicable when dealing with credit cards, loans, mortgages, and other debt products.
The Role of APY
Here’s a closer look at APY’s role in savings accounts, CDs, and fixed and variable-rate investments.
APY in Savings Accounts
The APY in savings accounts is the actual growth of your funds over a one-year period, including any interest earned and added to your balance.
APY in Certificates of Deposit (CDs)
The APY in certificates of deposit (CDs) also shows the actual return on your investment over a one-year period. CDs come with fixed terms and interest rates and typically compound annually. So, you’ll know exactly how much you’ll earn from inception.
APY in Fixed and Variable Rate Investments
The APY in fixed-rate investments provides a clear picture of what you’ll earn, regardless of market conditions. But if you have a variable rate investment, the APY will likely fluctuate with market conditions, and your earning potential will vary.
Factors Affecting APY
Below is a closer look at the factors that affect the APY you earn on savings and investment accounts.
Interest Rate
It represents the percentage of your balance that your bank or broker pays you as interest over a certain period. The higher the interest rate, the higher the APY.
Compounding Frequency
Compounding refers to how often the interest earned is added to your account balance. The more frequently the interest is compounded, the higher the APY. Remember, Monthly or quarterly compounding is less frequent and typically results in a lower APY than daily compounding.
Account Fees
Account fees, including monthly maintenance fees, transaction fees, or penalties for not maintaining a minimum balance, can negatively impact your APY by reducing your earning potential.
How to Maximize Your APY
A higher APY means you’ll earn more on your money, so you should explore ways to boost this percentage.
Choosing the Right Financial Products
You want to pick the right financial products to maximize your earning potential. Think high-yield savings accounts, money market accounts and certificates of deposit (CDs), as they generally come with higher APYs than standard savings accounts. (Note: CDs typically feature higher APYs but require you to lock in your money for a set period in exchange for a fixed return. If you need to withdraw the funds before the CD term ends, you’ll likely incur a penalty).
It’s also worth noting that online banks often provide better rates than traditional brick-and-mortar banks due to lower operating costs. So, to maximize your APY, consider the financial products offered by these entities.
When exploring account options, confirm that the financial institutions you’re considering are FDIC—or NCUA-backed. This coverage protects your hard-earned money—up to $250,000 per account, per depositor—in the unlikely event the bank or credit union closes.
Compounding Strategies
The rate at which interest compounds is also important if you’re looking to derive the greatest return on your money. Consider products that compound interest more frequently—the more often interest compounds, the higher the effective yield on your investment.
Minimizing Fees
Fees on savings and investment accounts can dent the benefits you’ll derive from a high APY. Pay special attention to monthly maintenance fees, early withdrawal penalties, administrative costs and other charges that can minimize your earnings.
Risks and Considerations with APY
Misleading APY Offers
Some financial institutions promise steep APYs, but the deals might be deceptive. To illustrate, banks might advertise an enticing APY that may only apply when certain conditions are met. Introductory offers can be another issue. Some banks promote high APYs, but these rates often drop after an initial period.
Market Fluctuations and APY
Market conditions also impact APYs offered by banks, credit unions and other financial institutions. When rates are low, the APY on savings accounts and other investments may decrease substantially.
Market conditions can also impact the frequency of interest compounding, with some financial institutions adjusting their compounding schedules based on market stability. This, in turn, impacts the actual APY and interest earnings you receive.
The earning potential on investments that come with variable interest rates is tied directly to market conditions. If market conditions deteriorate, the anticipated returns on these investments will likely be much lower than expected. But if they improve, you could surpass your earnings goals.
Conclusion: The Importance of Understanding the Annual Percentage Yield (APY)
It’s vital to know what APY represents and how it compounds. To recap, it shows how much interest you earn on your savings over a year and can compound at different intervals. When comparing savings options, always look at the APY, as a higher percentage means more generous returns.
FAQs on APY
Yes, APY can change over time. The Annual Percentage Yield (APY) depends on the interest rate your financial institution offers. These rates can fluctuate based on the overall economic environment, including changes in the Federal Reserve’s policies and market conditions.
It’s relatively common for APY to be paid monthly, but it could also be paid quarterly, annually or at other intervals.
