Table Of Content
What Does APY Mean?
APY stands for Annual Percentage Yield. It's a measure of the annual rate of return on an investment or savings account, expressed as a percentage. APY takes into account both the interest rate being offered and the frequency of compounding, which is the process of earning interest on interest.
For example, if you invest $1,000 in a savings account that pays an annual interest rate of 5%, compounded quarterly, your APY would be higher than 5% because you would earn interest on the interest that was earned each quarter. The more frequently interest is compounded, the higher the APY will be.
Why Use APY And Not Simple Interest Rate?
APY, or Annual Percentage Yield, is used instead of the simple interest rate because it provides a more accurate measure of the actual rate of return on an investment or savings account. The APY takes into account the effect of compounding, which is the process of earning interest on the interest that has already been earned.
For example, if a savings account offers an interest rate of 3% per year, but compounds interest monthly, the APY will be slightly higher than 3% because interest is earned on the balance, including any previously earned interest, each month. The more frequently interest is compounded, the higher the APY will be.
Using APY instead of the simple interest rate allows savers and investors to compare the actual return they can expect from different financial products more accurately. For example, two savings accounts may have the same interest rate, but if one compounds interest daily and the other compounds interest annually, the APY will be higher for the account that compounds interest daily.
Which Financial Products Use APY?
In general, any financial product that pays interest or dividends may use APY as a way to express the rate of return to investors. Some financial products that may use APY include:
Money market accounts (usually compounded daily)
- Certificate Of Deposits (usually compounded daily)
High-yield checking accounts (usually compounded daily)
Online savings accounts (usually compounded daily)
Treasury bills and notes (usually compounded semiannually)
Is APY Variable Or Fixed?
Usually, it's variable, meaning it can change over time based on market conditions or other factors. Many savings accounts, CDs, and other investments offer variable APYs, which can rise or fall depending on changes in interest rates or other factors.
For example, a savings account may offer a variable APY of 2%, which means that the actual rate of return can change over time based on changes in the underlying interest rate. If FED interest rates rise, the APY on the savings account may also increase, resulting in a higher rate of return. Conversely, if interest rates fall, the APY on the savings account may also decrease, resulting in a lower rate of return.
Variable APYs can be beneficial in some cases because they allow investors to potentially earn higher returns if interest rates rise. However, they can also be more unpredictable and may make it more difficult to plan for long-term savings goals.
How To Calculate APY?
APY, or Annual Percentage Yield, is calculated using a formula that takes into account both the interest rate being offered and the frequency of compounding. The formula for APY is:
APY = (1 + (r/n))^n – 1
- r is the interest rate being offered
- n is the number of compounding periods in a year
For example, if a savings account offers an interest rate of 5% and compounds interest monthly (n = 12), the APY would be calculated as:
APY = (1 + (0.05/12))^12 – 1 = 0.0511 or 5.11%
In case the interest is compounded daily, we would need to use the following formula:
APY = (1 + (0.05/365))^365 – 1 = 0.0512 or 5.12%
In case the interest is compounded semi-annually, we would need to use the following formula:
APY = (1 + (0.05/2))^2 – 1 = 0.0506 or 5.06%
The formula shows that as the number of compounding periods increases, the APY will also increase. This is because with more frequent compounding, the interest earned is added to the principal more often, resulting in more interest earned over time.
APY vs. APR: What's The Difference?
APY and APR are both measures of the rate of return or cost of borrowing, but they are calculated differently and used for different types of financial products.
APY calculates the rate of return on savings accounts, CDs, and other investments that earn interest. APY takes into account the interest rate being offered and the frequency of compounding. The APY reflects the actual rate of return on an investment, including the effect of compounding, and is expressed as a percentage.
APR, or Annual Percentage Rate, is used to calculate the cost of borrowing money, such as on credit cards, loans, and mortgages. APR takes into account not only the interest rate being charged, but also any fees or other charges associated with the loan.
The APR reflects the total cost of borrowing, including the interest rate and fees, and is also expressed as a percentage. APR is typically lower than the nominal interest rate because it does not take into account the effect of compounding.
How APY Can Be Impacted By Inflation?
APY doesn't directly impact by inflation, but inflation has an impact on the interest rates. When inflation rises, interest rates typically rise as well , and when inflation falls, interest rates typically fall too. Since interest rates sets the APY, inflation has an impact on how the APY changes on your deposits.
Central banks often use interest rate policies to manage inflation, aiming to keep it within a certain target range. If inflation is rising above the target range, central banks may raise interest rates to reduce the money supply and slow down the economy. A great example is the recent increase in the FED rates due to the high inflation in the US.
Higher interest rates can help to offset the effects of inflation by providing a higher return on investments and savings accounts.
What Is A Good APY For A Savings Account And CDs?
As of May 2023, a good APY on savings can be anywhere above 4% APY, and a good APY on CDs is about 5% APY and more.
CDs APY tend to be higher than savings accounts, and long-term CD rates are higher than short-term CDs.
Here's a comparison as of May 2023:
1.00% – 4.25%
3.70% – 4.75%
3.90% – 4.75%
2.00% – 4.75%
3.75% – 4.75%
Up to 4.81%
2.00% – 4.80%
How does compounding impact APY?
Compounding can help increase the total interest earned on an investment, as the interest earned is added back to the principal and begins earning interest itself.
What is the difference between simple interest and compound interest?
Simple interest is calculated only on the principal amount invested, while compound interest is calculated on the principal amount plus any interest earned over time.