What Is APY and How Does It Work?

APY, or Annual Percentage Yield, is an important term to understand if you want to maximize your money’s growth potential. It measures the interest earned on a financial product or account over one year. The higher the APY, the faster your account will accumulate interest.

Knowing how to calculate APY and how it affects your investments can help you make informed decisions about where to invest your money.

What Is APY?

APY is a formula used to calculate the amount of interest earned on an investment or savings account over one year.

Though it is often used interchangeably with the term “yield,” there are some critical distinctions between the two. For one, APY takes the effect of compounding interest into account.

This means that your money earns interest not only on the principal investment, but also on the interest you’ve already earned. Since your account balance will get bigger each month from the added interest, the interest paid on this balance will increase as well.

How Is APY Calculated?

Use the following formula to calculate APY manually. If you need to know your interest rate, you can ask your bank or credit union for the information. For credit cards, check your monthly statements.

When calculating APY for a compound interest account, you need to consider the number of compounding periods. For example, a typical interest account will have interest calculated once per year, but some accounts will calculate interest multiple times per year. You can find the APY of your account by multiplying the stated interest rate by the amount you have in the account.

For example, suppose you have $5,000 in a  CD account with a 3% interest rate. If it’s compounded monthly, the formula will look like this:

APY = (1 + 0.03/12)¹² – 1

APY = 3.04%

To find out how much money you’d have at the end of the year, multiply your initial deposit by the APY. In this case, your final account balance would be $5,152.08.

How Does Compound Interest Work?

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.

Compound interest works on a schedule. It 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. Because it acts as a money multiplier, compound interest is one of the best ways to grow your savings.

Let’s say you have $10,000 in a high-yield savings account and earn 5% interest on this money. By the end of the year, you will have made $500 in interest and have $10,500 in your account. This might not seem like a huge sum, but compound interest builds over time.

If you keep that $10,500 in the same account the following year, you’ll earn the same 5% interest rate but on the new amount of $10,500 rather than the initial $10,000. This means that you will have $11,025 in your account at the end of the second year. By the end of year three, you will have made a total of $1,577 in interest alone.

Is APY Variable?

APY can be variable on some financial products like checkings and savings accounts. However, other financial products, such as certificates of deposit, offer a fixed APY.

Variable APYs generally respond to rising or falling market interest rates. These benchmark interest rates are set by the Federal Reserve. Thus, when the Federal Reserve raises the benchmark rates, variable APYs tend to rise, and when they decrease the benchmark rates, variable APYs will also decrease.

What Factors Affect APY?

Several factors can affect the annual percentage yield on your investments and savings accounts. The most significant factors are interest rates, compounding frequency and the length of the investment.

In general, the higher the interest rate on your account, the more likely it is your account will yield a higher APY. However, interest rates are not static, and they fluctuate over time. A change in interest rate could mean a significant difference in your APY, which is why the interest rate on your account is something you should always monitor closely, especially if you are investing for the long term.

Compounding frequency can also affect the APY on your account. Simply put, the more often interest is compounded, the more interest you will earn over time. Generally speaking, long-term investments, such as retirement savings accounts, will have lower interest rates than short-term accounts like standard savings accounts.

Takeaway

APY is an important term to understand if you want to maximize your money’s growth. APY measures the interest earned on an investment or savings account over one year and considers the effect of compounding interest. Knowing how to calculate APY and how it affects your investments can help you make informed decisions about where to put your money. When comparing different types of financial products, always compare their APYs to make an informed decision.

FAQ

• What does 5.00% APY mean?

  • A 5.00% APY means that your account will yield an interest rate of 5% after one year. For example, if you deposited $1,000 in an account with a 5.00% APY, you would earn $50 in interest. However, if the APY were compounded monthly, the effective rate would be 5.12%, and you would earn $51.16 in interest.

• Is APY paid monthly?

  • APY is paid in set periods. For example, some APYs are paid daily, while others are paid monthly or annually.

• What is a good APY?

  • There is no set number that defines a good APY, as each financial product has different benchmarks. However, higher APYs will always generate more money from interest than lower APYs. The national average savings account APY is 0.24%, but it is possible to find higher APYs. Always shop around for the best rates.

• APY vs. APR: what's the difference?

  • APY and APR are two different ways to measure interest rates. APY stands for Annual Percentage Yield, meaning the total amount of interest earned on an account in a given year. APR stands for Annual Percentage Rate, which is the total cost of borrowing money over 12 months.

  • The main difference between the two is that APY considers compound interest. If the interest compounds at a more frequent rate, such as monthly or daily, there will be a greater difference between the APR and APY.

Valerie Smith contributed to the reporting for this article.

Data is accurate as of Dec. 5, 2022, and is subject to change.

This article originally appeared on GOBankingRates.com: What Is APY and How Does It Work?