APY is typically used to indicate the amount of interest you’ll earn on an interest-bearing account—like a certificate of deposit (CD) or savings account—annualized over the course of a year. APY reflects the real rate of an investment's return by factoring in the effect of compound interest, thus making it a widely used indicator of value when dealing with interest-bearing products.
But how does APY work? What types of account balances does it usually apply to, and what does APY mean for your investment portfolio?
Follow this guide to better understand the importance of APY. Within it, you’ll learn how to calculate and compare APY rates to maximize your growth potential with minimal risk. 🤓
What we’ll cover:
- What compound interest is and how it affects the overall growth of an investment.
- Where to find an account’s APY and how to compare different APYs based on the frequency of compounding.
- How to calculate an account’s APY and determine how much you’ll earn over a year.
- How to balance risk against APY.
What is APY?
APY stands for annual percentage yield. It’s used to determine how much your investment will return in a given year. APY directly reflects how much an investment is expected to yield in interest alone.
At first glance, APY seems like just another definition for simple interest. The difference, however, is that the formula for calculating APY takes into account the effects of compound interest, which provides a more accurate forecast of ROI.
Are you confusing APY with APR? You’re not alone. Learn more about APR in our Simple Guide to Annual Percentage Rates.
What is compound interest?
Compound interest is, essentially, interest earned on interest. In contrast, when you’re dealing with simple interest, the return will be the same each year. With compound interest, the return will increase.
For example, assume you have a beginning balance of $1,000 in an account with a 5% interest rate. In the first year, the investment grows by $50 (5% of $1,000). The next year, however, your 5% interest will be calculated on both the original $1,000 and the additional $50 you earned through interest. Because of compound interest, you’ll earn a second-year return of $52.50 (5% of $1,050). Interest may also compound more than once per year. More frequent compounding offers a slight increase in your return, and the total amount of interest grows more over the same period of time!
It may not seem like much of a difference, but that same $1,000 investment collecting compound interest over ten years, grows to be $1,628.89 - a return of over 50% in growth!
When comparing two different accounts, a compound interest calculator can help you accurately forecast your growth. Play around with this calculator from investor.gov
What’s a typical APY?
A typical APY depends largely on what financial product is being used and which institution is offering it. Here are a few examples to keep in mind.
- Checking accounts: It’s common for these to have a 0% APY, or something very close to it. However, some of the highest-yielding checking accounts have an APY of around 1%.
- Online savings accounts: Yields on savings accounts fluctuates with the Federal Reserve Rate, with yields right now averaging 0.33% APY, but there are some accounts (especially online banks) that offer yields well over 1-3+%.
- CDs: Returns on certificates fluctuate as well. Right now, they have an average APY of around 0.15%. However, it is not uncommon to find CDs offering yields of around 2% depending on the economic climate.
- Mutual funds: Though they are considered a riskier option, they tend to offer a much higher APY. Returns are not guaranteed unlike the options above, but the average mutual fund return in 2021 was 11.54%.
As you understand more about APY and how it works, you should strive to make the most of your investments. Knowing about the standard range of APY across accounts, and the risk associated, will give you a better sense of which account is right for you.
What is a good APY?
A good APY could roughly be defined as having a yield that beats the average. According to the FDIC, the national average APY for savings accounts in the United States is approximately 0.17%.
So, what is a good APY for a savings account? Well at the time of this writing, a good APY would be anything greater than 0.17%. It is a good rule of thumb to use the average as a starting point and look to put your money into accounts with significantly higher yields.
It is important to know what a good APY is so you can put your money into accounts that will be worth your while.
How to find the APY for an account
Finding an account's APY is simple enough. Thanks to the Truth in Lending Act, banks and other financial institutions must disclose a financial product’s APY and other account details to investors and borrowers.
Can’t find an account’s details in its description or terms? Don’t enter into an agreement until you’ve been provided with all the product’s information, including the APY.
How to calculate APY
You can use a good old fashioned formula to calculate APY—or, if you’d rather avoid the math, use an APY calculator like this one. The formula used to calculate APY is:
APY = (1+r/n)n - 1
In this case, “r” is the listed interest rate, which may compound monthly, quarterly, or at some other interval. “n” is the number of compounding periods during the year.
Let’s work with an interest rate of 0.05% which compounds monthly. This will be converted to a decimal for the equation, becoming 0.0005.
The formula would become:
APY = (1+0.0005/12)^12-1
This equals 0.00050011, or an APY of 0.05001%. We can use that figure to determine how much the savings will earn over one year when the effects of compounding interest are taken into account.
That formula is::
(APY x p) + p = t
“p” stands for principal, and “t” stands for total earnings after a year.
Let’s say your initial deposit (i.e. the principal) is $50,000. Convert the APY percentage back into a decimal and away you go:
(0.00050011 x 50,000) + 50,000
So with all of this math done the interest earned on your initial deposit will generate $25.01 in the year. While this may not seem like an impressive gain, the compounding effect can make a significant difference over a longer period of time.
Variable APY vs. Fixed APY
When looking at a bank account, you may see the terms ‘variable’, or ‘fixed’ being used to describe APY. Part of understanding APY is knowing the difference between these two terms.
An account with a variable APY has a rate of return that can change at any time. Variable rates are typically used on savings or investment accounts, as these may fluctuate according to the market.
The rate on a fixed APY will stay constant over a given term. CDs are a perfect example of an account type that usually has a guaranteed fixed rate.
APY vs. APR
While APY and APR (annual percentage rate) are both annualized expressions of interest rates, APY takes into account the effects of compound interest but not account fees or similar additional costs. It describes money gained by an investor.
APR is the annual percentage charged to a customer on lines of credit, such as credit cards and loans. APR does not factor in compound interest, but it does include added charges and fees. It usually describes a cost to the borrower. Like APY, an APR can also be fixed or variable, depending on the type of account or lender.
Learn more about the similarities and differences between APY and APR in our comparison guide.
Understanding APY and risk
The APY you will receive on your money usually comes down to how much risk you are willing to take. Generally speaking, the higher the risk, the higher the APY.
For example, checking accounts tend to have very low APYs because funds usually aren’t invested behind the scenes and therefore there is little to no risk of loss to the customer. But for savings accounts, there are usually withdrawal and holding limits, and they tend to have a slightly higher APY than checking deposit accounts because money is being invested to some degree behind the scenes and returned to you.
Looking for a middle ground? Money market accounts pay higher interest rates like savings accounts but still allow you to make withdrawals like a checking account. The catch however is money market accounts are typically still limited to a few withdrawals per month and aren’t intended to be used as a replacement for a checking account. They may require bigger minimum deposits and balances compared to savings accounts.
Mutual funds and stock accounts offer a much higher APY than all three of these because there is a significantly higher risk of losing your money. Why is that the case? Well because they are pure investment accounts and not designed to hold idle money.
💡Bonus Option: CDs have an even higher APY than savings accounts because money can’t be withdrawn at all until their term, usually years at a time, is completed.
If you’re looking for a low-risk, out of the box, investment opportunity, consider loaning money to a friend or loved one using Pigeon. You can invest in a business or endeavor of your loved one while setting your own personal loan terms, including APY.
What Is a high-yield savings account?
A high-yield savings account offers a significantly higher interest rate than the average savings account. They tend to pay up to 20-25% higher than the average yield, landing their APY at around 2-4+% depending on the current Federal Reserve rate.
A clear pro of these accounts is that you will be earning significantly more than you would from a standard savings account. With that being said, these accounts are not as readily available and sometimes require large deposits of money to open.
If you’re looking for a safe account to earn a solid amount of interest in, a high-yield savings account may be a perfect fit for you.
The bottom line
Annual percentage yield is important to understand for several reasons. First, it gives you a more accurate estimate of how much your investment will earn over a period of time. Second, being able to compare APYs will give you a sense of where the best returns are when making a personal financial investment.
APY is one of the most powerful financial metrics for savers and investors to know, and now you have the knowledge and tools at your disposal to make more educated decisions moving forward.
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