What Is APY and How Is It Calculated?

The concept of Annual Percentage Yield (APY) relates to the actual interest earned on an investment or bank account over a year, including the effects of compound interest. Unlike simple interest, APY incorporates how often interest is compounded, resulting in a higher effective return. This makes it a useful metric for comparing financial products, as it provides a standardized way to express the real growth rate of an investment on an annual basis.

APY is pertinent to savings and checking accounts, as well as certificates of deposit (CDs), and can be either variable or fixed. A variable APY can fluctuate based on changes in economic conditions, while a fixed APY remains constant. Generally, accounts offering higher APYs require greater sacrifice, such as limited access to funds, in the case of CDs.

Banks are required to show the APY on their interest-bearing accounts in the U.S., allowing consumers to make educated comparisons between different products. The formula for APY is (1 + r/n) ^ (n) - 1, where r is the nominal interest rate and n is the number of compounding periods per year.

Overall, APY enables investors to compare various investment returns by accounting for compounding, which simple interest rates do not. While APY measures the growth of your money, APR (Annual Percentage Rate) is a similar concept used in the context of loans and the cost of borrowing, excluding compounding.