What Is APY?
When it comes to banking, there are plenty of acronyms that maybe only financial industry pros instantly know what they mean. Think ACH. DDA. FCRA. LTV. NSF.
One member of this alphabet soup family that every consumer should know, however, is APY. That’s because it helps them to know just how much money they stand to earn in terms of interest.
APY stands for annual percentage yield, and it is a key financial metric designed to give bank account holders a clear understanding of the interest income generated by their deposits. APY does this by measuring the amount of interest paid on money that is held in an account for a full year, whether it’s a savings account, interest-bearing checking account, money market account or certificate of deposit.
Understanding APY is useful for a number of reasons, including helping you keep track of where your finances are now and where they might be a year from now. Keep reading to learn more about what APY is and how it can affect your savings.
What Is APY and How Does It Work?
The simplest way to look at APY is that it’s the projected rate of return over the course of a year, after accounting for compounding interest. So before you can grasp APY, you need to know how compound interest works.
Compound Interest
Compound interest is the interest you earn on all the money in your account — not just the principal deposit, but also the interest itself. This distinguishes compound interest from simple interest, which is the interest you earn on the deposit only.
Interest can compound in different increments, including daily, monthly, quarterly and annually. With APY, the money earned in interest is annualized over the course of a year.
How To Calculate APY
Because APY includes both the interest rate and the impact of compounding interest, calculating it requires more than just plugging in a couple of numbers, the way you would with simple interest. Here’s how to calculate APY.
A much easier way to calculate APY is by using a compounding interest calculator. If you have one, here’s the info you’ll need to input:
Initial deposit amount
Amount of money you plan to deposit each month
APY and compounding frequency for the account
Amount of time you plan to save and let the interest compound
APY = (1 + r/n)n – 1
How Does APY Work Per Month?
Suppose you have a savings account that pays an annual 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 slightly 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 a year, but the same amount will grow to $50,603 if the compounding period is monthly.
Why Is APY Important to Savings?
The main reason APY is important is that it can give you an idea of how the money in your savings account — or any interest-bearing account — is working for you. The higher the APY, the greater the return.
That’s why savvy bank customers seek out high-yield savings accounts, which help them grow their money faster than with most standard savings accounts. Ensuring that your interest is compounded monthly instead of yearly brings an even higher return.
Understanding APY can also help you make smart decisions about how to allocate capital. It’s important to weigh the potential benefits and risks of different assets, including rate of return and opportunity cost. With a firm grasp of APY, you can assess the rate of return and opportunity cost of putting your money into a savings account or CD vs. another asset such as a stock or bond.
This is especially important for people on a fixed income. For example, retirees who partly depend on interest income need a clear understanding of how much cash flow a deposit account could generate to meet their basic needs and lifestyles. If the APY is insufficient to cover those costs, they’ll need to consider an alternative option.
Someone carrying a lot of debt might want to use funds from a deposit account to pay the debt down, but that might not be wise if the APY on that account is higher than the interest rate on the loan. This is a case when properly calculating the APY comes in especially handy.
What Is a Good APY?
You don’t need an economics degree to figure out that a “good” APY is one that’s much higher than average. The Federal Deposit Insurance Corp. reported that the average savings account interest rate as of July 18, 2022, was 0.10% APY.
A very good APY is one that earns 10 to 25 times more than the average savings account. A generation ago, a 5.00% APY wasn’t uncommon, but today’s rates don’t typically approach that, with the highest rates falling under 2.00%.
Are APY and APR the Same Thing?
A lot of people probably look at APY and APR — annual percentage rate — as interchangeable, but they’re actually two different things. APR measures the total cost of debt, expressed as an annual percentage, and applies to borrowing, such as credit cards and mortgage loans. Its calculation includes interest as well as fees, closing costs and other related expenses.
The APR is disclosed by lenders to help borrowers understand the actual costs of using a debt instrument. APR is so important in the analysis of debt that the U.S. government requires lending institutions to disclose APR whenever rates are advertised.
The APY is also a representation of interest, but it is disclosed by financial institutions to holders of deposit accounts — not debt — so that account holders know how much interest will accrue on an account. From the perspective of a consumer, APY is the opposite of APR, as it measures cash inflows rather than outflows.
Takeaway
Since APY impacts how much you can earn on your money, it’s worth doing the research to find the best account to stash your money. You work hard for your money. Put it back to work for you.
Vance Cariaga and Jami Farkas contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: What Is APY?
