Understanding APY: Annual Percentage Yield Explained

When it comes to investing and banking, you want to make sure you are getting the best interest rate. You will often see the term "annual percentage yield" (APY) when opening an interest-bearing account. APY is the yield you earn on a deposit over a year.

Significance

APY is the rate of return you will have receive on your investment in a year.

Function

The formula to calculate APY is (1 + r/n)^n - 1. The "r" is the interest rate in decimal form (3.45 percent would be written as 0.0345), "n" is the number of compounding periods per year and "^" is to the power of. If the interest rate is compounded quarterly, then "n" would be 4. Using these numbers in this formula would equate to a 3.49 percent APY.

Types

Banks and other financial institutions use APY to advertise interest-bearing accounts. You will see APY being quoted on savings accounts, interest-bearing checking accounts, money market accounts and certificates of deposit.

Compounding

Compounding is simply making earnings of your earnings or previously accrued interest. The more the interest is compounded, the higher the APY. APY can be compounded yearly, quarterly, monthly or daily.

Comparing Rates

You can use the APY formula to compare how different interest rates with different compounding frequencies affect your total interest. For example, a lower interest rate that is compounded more frequently may give you a higher APY than a higher interest rate compounded less frequently.