The term 'Annual Percentage Yield (APY)' is included in the Banking edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
APY describes the amount of compound interest which individuals or businesses will earn in a given year (or longer time period). Investments in money market accounts, savings accounts, and CD Certificates of Deposit all pay out such interest. It is the annual percentage yield that demonstrates precisely the amount in interest individuals will receive. This is helpful for people or businesses trying to ascertain which investments and banks offer superior returns by comparing and contrasting their real yields. In general, higher Annual Percentage Yields are better to have (unless one is comparing interest on credit card debts).
This APY is practical to understand and measure simply because it considers compound interest and the miracle of compounding within any account. Simple interest rates do not do this. Compounding is simply earning interest on interest that has already accrued and been paid. It signifies that individuals are gaining a greater amount in interest than the corresponding interest rate literally indicates.
It is always a good idea to consider a real world example for clarification purposes. If Fred deposits $10,000 into a particular savings account that provides a two percent yearly interest rate, then at the end of that first year Fred will have $10,200. This assumes that the interest is paid one time per year. If the bank were to figure up and pay out the interest on a daily basis, it would increase the amount to $10,202. The extra $2 may seem small, but given a longer time frame of from 10 to 30 years, this amount can add up, particularly if larger deposits are involved.
APY should never be confused with APR. They have some similarities, but APR does not consider compounding. It is once again a simpler means of computing interest. Credit card loans are an area where it is important to understand the differences between annual percentage rate and annual percentage yield. When people carry a balance, they will be paying higher APY’s then the APR the firm actually quotes. This is because interest is assessed monthly, which means that interest on the interest will be computed on each following month.
The key to obtaining a better APY on investments and savings accounts lies in getting as frequent a compounding period as possible. Quarterly compounding is better than annually, yet daily is the most superior form of compounding possible. This means that as individuals are looking to increase their APY’s personally, it is important to have the money compounding as frequently as they can practically achieve.
When two CD Certificates of Deposit pay out the same rate, it is best to select that one which actually pays out both more frequently and also boasts the greater APY. With CD’s, the interest payments become automatically reinvested. More frequent reinvestment is always better. This will help any individual or business to earn a greater amount of interest on the interest payments already earned and paid out.
Calculating the annual percentage yield is not an easy task. Business calculators as well as computer algorithms mostly do it for people nowadays. The simplest way to find the APY for a given account is to plug in the information including the initial deposit, compounding frequency period, interest rate, and amount of overall time for the period considered. These smart calculators will then tell you both the effective annual percentage yield as well as the ending balance on the hypothetical account at the end of the given time period.