When you invest your money, you expect to earn some sort of return. Broadly speaking, riskier investments promise larger potential returns. With things like certificates of deposit or savings accounts, banks need a way to measure the return that you can expect. Enter the annual percentage yield (APY). An APY is a percentage that tells you how much you’ll earn on an investment including compound interest in one year.
How to Calculate the Annual Percentage Yield
The annual percentage yield formula is (1 + (i / n))n – 1. In that equation, i is equal to the annual interest rate and n is equal to the number of times that interest compounds each year. If your interest rate is listed as a periodic rate (a 1% monthly rate, for example), you can substitute that for (i/n).
To see how the annual percentage yield plays out in real life, we’ll look at an example. Let’s say you’re considering opening a savings account, and the annual interest rate is 2.5%, compounded monthly. Plugging those numbers into the formula, you’d get (1+(0.025/12))^12 – 1. That would result in an APY of 2.529%.
How Compound Interest Works
When you invest your money, your goal is to earn as much interest as possible. Many refer to compound interest 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 the interest compounds, 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.
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.
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.
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 together. Plus, the APR generally includes fees, which APY doesn’t account for.
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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