The annual percentage yield, APY, measures the amount of interest paid on banking deposits, such as savings accounts and certificates of deposit, that are held in an account for a full year. It helps to get a better view of potential income that can be earned on daily, monthly, or quarterly compounding periods.
Understanding APY is important, so read on to get a better understanding of it.
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Table of Contents
What Does APY Mean?
APY is a metric that helps holders of deposit accounts to accurately understand the amount of interest income their account is generating. It only applies when the compounding periods on the account are shorter than one year; monthly and quarterly periods are both common.
Each month, the interest paid in the previous period is added to the account, and interest is paid on these new funds as well, resulting in a compounding effect. This can substantially increase the income potential of simple interest rates.
How Do I Calculate APY?
APY includes both the interest rate and the impact of compounding interest. If you would like to calculate APY, do the following:
- Step 1: The simple annual interest rate is divided by the number of compounding periods in each year.
- Step 2: The resulting number is then added to one.
- Step 3: The number is raised to the power of the number of compounding periods.
- Step 4: One is then subtracted from the number to provide the APY.
This is the equation it follows:
APY = (1 + (periodic rate ÷ number of times compounded)) ^ (the number of periods in a year) – 1
The number of compounding periods is usually one per month, although daily and quarterly periods are also used for some accounts, such as certificates of deposit.
For example, consider a savings account paying a 1.20% interest rate with interest paid on a monthly basis. Each month, this account will pay 0.10% interest on the balance, and the new funds will compound. The resulting APY will be 1.21%, which is somewhat higher than the simple interest rate on the account. An account with $50,000 at the above rate will grow to $50,600 if interest is only applied once annually, but the same amount will grow to $50,603 if the compounding period is monthly.
Distinguishing Between APY and APR
APY is often confused with APR, which is the annual percentage rate. APR measures the total cost of debt in annual percentage form. The calculation includes interest as well as fees, closing costs and other related expenses.
Lenders offer this number to borrowers to help them understand the actual costs of using a debt instrument. APR is very important for debt purposes, therefore institutions are required by the government to disclose APR rates.
APY also represents interest, but it is deemed the opposite of APR. However, it measures cash coming in rather than cash coming out.
Why is APY Important?
APY is essential when assessing the rate of return and opportunity cost of allocating to a savings account or CD compared to another vehicle.
Those who have retired may live off of the income generated by interest on accumulated assets must understand how much cash flow a deposit account could generate to meet their basic needs and lifestyles. If APY is insufficient to cover those costs, an alternative option should be considered.
Someone carrying debt might want to take funds from a deposit account to retire the loans, but it might not be the best decision if the APY on that account exceeds the interest rate on the loan. The calculation of APY would be even more meaningful in this case if the loan interest rate happened to fall between APR and APY.
APY is a popular and important measurement that accurately depicts the money you earn on deposits into savings accounts or certificate of deposits.
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