How APY Works

What is APY?

APY is an acronym for annual percentage yield, a term commonly used in banking to denote the effective annual rate of return on a savings account. When doing due diligence on various savings accounts, money markets or certificates of deposit, one is likely to encounter the terms APY, interest rate and compounding method. APY is a measure that takes the interest rate of an account and factors in the compounding rate to arrive at actual percentage rate of return that the account will earn over a year. When researching savings accounts, APY is the most important number to compare to determine which will earn the most interest.

Calculating APY

APY can be calculated as long as one knows an account's interest rate and compounding period length. The formula for calculating APY is: APY = (1 + i/n)^n -- 1. In this equation, "i" is set equal to the nominal interest rate, and "n" is set equal to the number of times the account compounds over a year. So for an account that compounds monthly, n equals twelve, and if it compounds yearly, n is equal to 365. For accounts that compound continuously, meaning n is essentially infinitely large, the formula APY = e^i -1 is used. In this formula, "e" is the base of the natural logarithm (approximately 2.718) and "i" is the nominal interest rate. A similarly accurate calculation of a continuously compounding account could be attained using the first formula and using a very large value for "n."

APY Versus Interest Rate

The difference between APY and interest rate is a common source of confusion for many potential savers. APY is the annualized rate of return factoring in the compounding of money within the account, while the interest rate is the nominal interest rate at which the account grows. The interest rate does not take into account the fact that most savings accounts allow money to begin accumulating interest on interest earned earlier in the year (this will be true for any account that compounds more frequently than once a year), and consequently the APY on an account will always be equal to or greater than its interest rate. Most savings accounts compound either monthly, daily or continuously: The more frequently the account compounds, the larger the difference between its interest rate and APY.