- Annual percentage yield (APY) is the rate of return you earn over a year on deposit accounts, like CDs, savings, and checking.
- The APY can be fixed or variable and includes compound interest — so you earn interest on your original balance plus any previously earned interest.
- The APY on a deposit account changes based on whether the economy is doing well and when the Fed raises interest rates.
There are many ways to invest your money to earn more. Investing in the stock market is one way to go about building wealth over time, but it’s not for everyone. Some prefer to take a more conservative approach and earn money through deposit accounts that offer an APY, or annual percentage yield.
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What is an annual percentage yield?
An APY is what you’ll earn on interest on a deposit account over the course of a year. It’s common for consumers to earn an APY through deposit accounts such as savings accounts, certificates of deposits (CDs), and money market accounts. An APY is always expressed as a percentage and is what you’ll earn on funds that you keep in your account year around.
“It is generally assumed the investment is to be held for 365 days,” says Laura Lonie, CPA and Financial Coach at Laura J. Lonie LLC. Lonie adds that this is helpful when consumers are comparing various CDs or deposit accounts in that they can better understand what they can earn on their money without having to calculate the interest themselves.
Use Personal Finance Insider’s compound interest calculator to see how much your money can grow
Your balance after 5 years
How does APY work?
APY calculates the total amount of interest earned in an account over the course of one year. It includes your interest rate and your compounding interest, or what you earn on the principal amount plus the interest on your earnings.
“A savings account held for one year at a lower interest rate than one held for two years may have a higher amount of interest earned because interest is compounded more frequently on the one-year term account,” Lonie says. “Because APY annualizes the investment, a consumer can compare APYs even though they have different holding periods and interest may be compounded differently, such as quarterly versus monthly.”
You might see APY in products like savings, checking, CDs, and
. These are all considered deposit-type investment accounts.
How to calculate APY
To get a better sense of how APY works, let’s take an example. Here’s the formula for APY:
Let’s say, for example, you deposit $1,000 into a 12-month CD offering at 5% APY, compounded monthly.
Using the above equation, here’s that broken down:
(1 + 0.05÷12)12 – one
(1.0041666666667)12 – one
1.05116 – 1
$1,000 x 5.116% = $51.16 total interest earned.
The total amount in the account at the end of the year is $1,051.16.
Is variable APY?
The type of APY you have depends on the financial product you have, although many offer fixed APY. Some products like CDs offer fixed APYs while savings accounts have variable APYs.
Any accounts with a variable APY typically see rates go up and down with market interest rates. So when the Federal Reserve raises or lowers its target interest rate, variable-rate accounts typically follow.
“APY can be either fixed or variable, but most savings and
are variable,” Lonie says. “Interest rates change based on the economy and actions of the
. Certificates of deposits are at a fixed interest rate for a set period.”
APY vs. interest rate
APY and interest rates have some overlap, but they are different. While APY represents what you can earn on a deposit account, interest rate by itself commonly represents what you’re charged for an auto loan, credit card, or mortgage.
“The interest rate does not take into effect compounding interest, and the APY includes
,” Lonie says. “Interest rate is generally used for loans and APY for deposit-type accounts.”
One exception to interest rates representing what you will owe when repaying a loan are bonds. These are debt securities that often offer an interest rate — commonly referred to a coupon payment — represents how much you’ll earn back each year until the bond matures.
APY vs. APR
Both APY and APR use interest rates in their calculations, but APY uses compounding interest, where you get interest on the principal amount and the earnings. APR doesn’t have that.
“The APY includes interest earned on interest while the APR uses the simple interest method,” Lonie says. “Generally, APY is used for deposit-type accounts and APR for loans or credit cards.”
The bottom line
Using an APY is one of the best ways to determine your total return on a deposited account, like savings or money market. The higher the APY, the higher the return. Use this as you shop around for products that showcase APYs.