Annual Percentage Yield (APY)
The real rate of return earned on an investment in a year, taking into account the effect of compounding interest.
Definition
Annual Percentage Yield (APY) is the real rate of return earned on an investment in a year, taking into account the effect of compounding interest. While an interest rate tells you what a bank pays you, APY tells you what you will actually earn after your interest begins earning its own interest over the course of a year.
Why APY Matters
APY is the standard metric used by banks to advertise high-yield savings accounts and Certificates of Deposit (CDs). Because compounding interest works in your favor when you are saving money, banks use APY because the number is slightly higher and more attractive than the base interest rate.
When comparing two savings accounts, you should always look at the APY. It provides a standardized way to compare returns, even if one bank compounds interest daily and another compounds it monthly.
Practical Example
Imagine you deposit $10,000 into a savings account with a 5.0% interest rate that compounds monthly:
- Month 1: You earn about $41.67 in interest. Your balance is now $10,041.67.
- Month 2: You now earn interest on $10,041.67, so your payout is slightly higher ($41.84).
- Year End: By the end of the year, your total interest earned is $511.62.
Because your money compounded, your effective yield for the year was 5.116%. Thus, the bank advertises the account as having a 5.12% APY, not a 5.0% interest rate.
If you are borrowing money instead of saving it, you should look at the APR (Annual Percentage Rate) to understand the true cost of the loan.
Frequently Asked Questions
Why is APY higher than APR?
Because APY accounts for compound interest. As your money earns interest, that interest also begins earning interest, increasing the total yield over a year.