When you invest your money, you expect to reap some sort of reward. The saying goes that the greater the risk, the greater the reward. That’s sometimes true. For example, buying stocks, while risky, can potentially leave you with a higher returns than you’d get from buying bonds. If you’re trying to compare certificates of deposit or savings accounts, the annual percentage yield (APY) will tell you which one will give you the greater return on your investment. Not sure how the APY works? Read on to find out.
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How Compound Interest Works
The annual percentage yield matters because it shows you which financial product is worth investing in. It tells you what your rate of return will be over the course of a year. When applied to loans, the APY tells you the annual cost of taking on the debt. One factor that plays a major role in deciding the APY is compound interest.
When you invest your money, your goal is to earn as much interest as possible. Compound interest is often referred to as earning interest on top of interest. That’s because it’s the amount of interest you receive from your initial investment combined with the interest earned on top of that number over a period of time.
Simple interest, on the other hand, is just the interest you receive from the money you actually invested. Compound interest is better for investors because it allows them to earn more money in a shorter amount of time. How quickly your earnings grow depends on how often interest is compounded, whether that’s daily, monthly, quarterly, twice a year or every 12 months. More frequent compounding means your money grows more quickly.
If you still don’t understand why compound interest is preferred, an example might clear things up. Perhaps you’re torn between putting $2,000 into a savings account with a 1% simple interest rate and an account with a 1% interest rate that compounds annually. After one year, you’ll have the same amount of interest, or $20.
After two years, however, you would earn $40 from the first account (with simple interest) and $40.20 from the account that compounds annually. That extra 20 cents is your interest added onto your original amount of interest. It doesn’t help much in the short term, but in the long run, compound interest can significantly boost your savings.
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Higher APYs Are Better for Investors
More compounding equals a greater amount of compound interest, and a higher APY generally indicates that the interest is compounding more frequently. So for savers, having a savings vehicle that compounds monthly is better than one that compounds once a year.
That’s not the case, of course, if you’re looking at the APY for a loan. If you’re trying to pay off your student loans, for instance, you would want a low APY and interest that compounds as infrequently as possible.
How to Calculate the Annual Percentage Yield
Now that you know what compound interest is, let’s take a look at how banks and other financial institutions calculate the APY. The annual percentage yield formula is (1 + (i / n))n – 1. In that equation, i is equal to the interest rate and n is equal to the number of times that interest compounds in a single year.
To see how the annual percentage yield plays out in real life, we’ll look at another example. Our money market account rate comparison tool says that the interest rate for a money market account at one bank is 0.75%. Based on that information, you can do the math. You’ll see that if the account compounds monthly (n=12), you’ll end up with an APY of 0.753%.
APY vs. APR
The annual percentage yield and the annual percentage rate (APR) are easy to mix up. The APR is the total amount of interest that accrues within a whole year for either taking out a loan or investing your money.
A regular interest rate only tells you the cost of taking on debt at one point in time. That length of time could be a day or a month. You’ll typically hear about the APR in reference to debt-related accounts like credit cards and mortgage loans.
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The biggest difference between the APR and the APY is compound interest. Unlike the APY, the annual percentage rate does not consider compound interest. That’s why the APR will likely seem lower if you see both the APY and the APR used in reference to the same account. Plus, the APR generally includes fees, which aren’t accounted for in the APY.
The Bottom Line
All savings vehicles have an annual percentage yield that shows investors how much they can earn within a year. Because the APY takes compound interest into account, it can be beneficial to people who are looking for opportunities to make the most of their investments. If you’re investing and you can’t choose between two accounts, it’s best to take the one with the higher APY, all things (including fees) being equal.
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