What is Annual Percentage Yield (APY)?

Annual percentage yield is like planting apple seeds to get more apple trees…

An apple tree grows apples. Those apples can produce more apple trees, and those trees can, in turn, produce more apples. APY helps you calculate how many apples you will get at the end of a year.

An interest rate (also called the simple or nominal interest rate) is the cost of borrowing money. For instance, when you deposit money into a savings or checking account, the bank is borrowing from you. The interest rate is the percentage of your deposit — or principal — the bank pays you for lending it money.

Annual percentage rate (APR) refers to the interest you’ll owe on an account in a year, often including both interest and fees. You typically see APR advertised for loans and credit cards. APR can you give you a better idea of what you’ll actually owe than simple interest alone. (However, note that APR doesn’t always include all fees.)

One drawback of APR is that it doesn’t consider the effects of compounding. That means it doesn’t reflect what happens when you pay or earn interest on interest you accumulate, which can occur daily in some cases. On investments, compounding helps you make more money, while on a loan or credit card, it can increase what you owe.

Annual percentage yield (APY) does take compounding into account — It reflects the interest you earn not only on your initial investment but also on interest you earn over time. You may see APY advertised for a savings account or a certificate of deposit (CD) since financial institutions want to emphasize the maximum that you stand to earn. One limitation of APY is that it doesn’t take into account fees or charges your account may incur. In general, the APY will be higher than the APR on the same account, if it has compounding interest and low or no fees.

There are a few steps to calculating annual percentage yield:

• Take your interest rate expressed as a decimal (r).
• Divide your rate by n, or how many times interest gets added to your principal in one year (the number of times your interest compounds).
• Add 1 to get (1 + r/n).
• Raise that value to n (again, that’s the number of times your interest compounds in one year), getting you to (1 + r/n)n.
• Finally, subtract 1 to get (1 + r/n)n - 1.
• To see APY as a percentage, multiply this value by 100.

Here’s an example of how to calculate Capital One’s 360 Performance Savings Account’s APY using its annual interest rate of 1.7853% in November 2019.

• First, take the interest rate of 1.7853%, or 0.017853 expressed as a decimal.
• Divide the interest rate by 12 times per year (interest compounded monthly). So, we have 0.017853 / 12 = 0.00148775.
• Add 1: 1 + 0.00148775 = 1.00148775.
• Raise that number to the number of times your interest is compounded per year. 1.0014877512 leaves us with 1.01799981.
• Now, subtract 1: 1.01799981 - 1 = 0.01799981.
• Your APY is 0.01799981, or about 1.80% expressed as a percentage.

The difference between APY and the annual interest rate may seem small, but it can add up over time.

It can be time-consuming to calculate APY by hand. Fortunately, online calculators will do it for you. If you type “APY calculator” in a search engine, you can find several options to choose from.

Please be advised that by searching for a third-party calculator, you’ll be accessing a third-party website. Robinhood Financial LLC is not implying that any monitoring is being done by Robinhood Financial LLC of any information contained on the third-party website. Robinhood Financial LLC is not responsible for the information contained on the third-party website or your use of or inability to use such site. Nor do we guarantee their accuracy and completeness.

When comparing savings accounts, a higher annual percentage yield will earn more interest. It’s essential to make sure that you are comparing apples to apples — or APY to APY. Some banks may also list the simple interest rate (also known as the advertised rate) or APR on their accounts.

You may not want to compare accounts based only on the advertised interest rates, because interest may compound at different frequencies. APY allows you to compare different accounts while taking into account compound interest.

According to the Federal Deposit Insurance Corporation (FDIC), the national average rate for a savings account as of November 2019 was 0.09% APY. A “good” APY may be one that is higher than average, although you may want to compare other account terms, such as fees, account minimums, and withdrawal limits.

Investors want their money to grow as much as possible in the shortest time. Annual percentage yield (APY) is a uniform way to measure which investment is the most profitable.

For example, let’s compare two hypothetical certificates of deposit. CD Option A offers a 5.0% interest rate compounded monthly. CD Option B offers a 5.0% interest rate compounded daily. Calculating the APY of each account can tell us which CD is more profitable.

Graphic Needed

CD Option B has a slightly higher APY than CD Option A because it compounds interest more often — 365 times instead of 12 times a year. With the higher APY, you can expect to earn a bit more interest with CD Option B.

The examples above are for illustrative purposes only and do not reflect the performance of any investment. Investing involves risk — You could lose your money.

When borrowing money, the annual percentage yield (APY) tells you the cost of accessing credit. The financial institution charges interest on how much money you borrow (the principal). Some credit cards charge interest on previously unpaid interest every day. Lenders and credit card companies often advertise annual percentage rate (APR) rather than APY. In reality, the APY is likely to be higher because of how frequently interest compounds.

Here’s an example of what happens if a financial institution quotes you APR. Depending on how often your account compounds interest — semi-annually, quarterly, monthly, or daily — you could actually be paying a much higher interest rate than advertised.

Pay close attention when researching the interest rate you’re getting with your credit cards and loans. APY can give you a better idea of how much debt you can accumulate in one year, allowing you to make the most informed decision. The bottom line is that a high APY is great for investments, but you likely want a low APY for credit cards and loans.