What Is APY and How Is It Calculated?

The annual percentage yield (APY) is the true interest rate earned on an investment in a year, incorporating compounding interest. A higher APY indicates a higher return, so comparing APYs across financial institutions ensures the best possible returns. APY shows the actual rate of return if the interest is compounded, with more frequent compounding leading to a higher APY. Unlike the annual percentage rate (APR), which is for loans and does not include compounding, APY accounts for compound interest but excludes fees. Therefore, while APY standardizes and accurately reflects investment growth, fees must also be considered for a complete picture.

Compound interest, a critical component of APY, allows investment returns to generate additional returns. Investment comparisons using APY are more accurate over simple interest rates, as APY illustrates growth from compounding. For instance, a certain rate could yield different outcomes based on compounding frequency. In investing or saving, APY tends to reflect risks or sacrifices made; for example, certificates of deposit generally have higher APYs due to the limited liquidity they offer. Overall, APY provides a clearer view of the interest rate you will earn, especially as it adapts to monetary changes like interest rate hikes by the Federal Reserve.