If you're about to open a savings account or discover that your checking account generates annual interest, it's essential to understand APY—what it is and how it's calculated. This metric represents the rate of return on your investment.
In this article, we’ll explain APY (Annual Percentage Yield), its calculation methods, types of APY, how to use it to compare investments, and how it differs from other interest rates. Keep reading to learn more.
What Is APY?
APY (Annual Percentage Yield) is the interest earned on an account balance that compounds, meaning it generates interest on previously accrued interest.
The compounding factor distinguishes APY accounts from simple-interest accounts. APY ensures you earn interest not just on your principal but also on accumulated interest over time.
Banks in the U.S. are required to disclose APY when advertising interest-bearing accounts, providing customers clarity on potential earnings over a 12-month period.
How Is APY Calculated?
APY is calculated using a formula that accounts for the account’s interest rate and compounding frequency. For example, a 2% interest rate compounded quarterly yields returns four times a year. If the same rate compounds monthly, it generates 12 periods of growth, resulting in higher overall returns.
APY Formula
To calculate APY manually, use this formula:
APY = (1 + r/n)^n – 1
Where:
- r = Interest rate
- n = Number of compounding periods
Federal law (Truth in Savings Act) mandates banks and credit unions to disclose APY, compounding frequency, and other account details. These figures allow you to apply the formula or use tools like spreadsheets or compound interest calculators.
Example Calculation
Assume a savings account offers 2% interest compounded quarterly (r = 0.02, n = 4):
- Divide the interest rate by compounding periods:
( 0.02 ÷ 4 = 0.005 ) - Add 1 to the result:
( 1 + 0.005 = 1.005 ) - Raise to the power of compounding periods:
( 1.005^4 ≈ 1.0202 ) - Subtract 1 to find APY:
( 1.0202 - 1 = 0.0202 ) (or 2.02%)
A $10,000 deposit would grow to **$10,202** in a year, surpassing the $10,200 from simple interest (2%).
Multi-Year APY Formula
For investments spanning multiple years:
APY = (1 + r/n)^(n*y)
Where:
- y = Number of years
Example: $10,000 at 2% interest, compounded quarterly over 3 years:
( (1 + 0.02/4)^{4*3} ≈ 1.062 ) → Final balance: $10,620.
Types of APY
- Fixed APY: Remains constant (e.g., Certificates of Deposit/CDs).
- Variable APY: Fluctuates with market rates (e.g., savings accounts, money market accounts).
👉 Explore high-yield savings accounts to maximize returns.
Using APY to Compare Investments
APY helps evaluate investment viability. For example:
- A 1-year zero-coupon bond at 6% vs. a money market account at 0.5% monthly compounding.
- The latter’s APY:
( (1 + 0.005)^{12} - 1 ≈ 6.17\% ) → Higher yield than the bond’s 6%.
APY vs. Other Interest Rates
| Metric | Definition | Key Difference |
|------------------|-----------------------------------------------|--------------------------------------------|
| Interest Rate | Simple interest earned on principal | No compounding; lower returns than APY. |
| APR | Annual cost of borrowing (loans/credit cards) | Reflects fees + interest; not for savings. |
| Dividend Rate | Payouts in credit unions (not interest) | Calculated via dividends, not compounding. |
APY in Cryptocurrencies
In crypto, APY measures returns from staking, liquidity pools, or savings accounts, accounting for compounded growth.
FAQs
1. Why is APY higher than the interest rate?
APY includes compounding, amplifying returns over time.
2. Can APY change?
Yes, if it’s variable (e.g., savings accounts). Fixed APY (like CDs) remains constant.
3. How often do banks compound interest?
Varies (daily, monthly, quarterly). Higher frequency = higher APY.
4. Is APY the same as APR?
No—APR applies to loans (cost of borrowing), while APY measures investment growth.
5. Where can I find my account’s APY?
Check bank disclosures, statements, or online account details.
6. What’s a good APY for savings?
Rates vary; high-yield accounts often offer 3–5%. 👉 Compare options.
Key Takeaways
- APY reflects compounded earnings, critical for comparing savings/investments.
- Formula: ( (1 + r/n)^n - 1 ) (adjust for multi-year investments).
- Fixed vs. variable APY impacts predictability of returns.
- Crypto APY rewards staking/liquidity participation.
For optimal growth, prioritize accounts with competitive APY and frequent compounding.