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*Updated on Thursday, October 14, 2021*

Annual percentage yield (APY) is a percentage that indicates an investment’s actual rate of return — in other words, how much it grows — in a year. The key difference between APY and an interest rate is that APY factors in compound interest. An APY is the most precise way to determine how much your money will grow over time.

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- Compound interest is earned and credited to an account balance on a regular schedule (whether that be daily, monthly, quarterly, so on).
- Compound interest applies to an account’s full balance — that’s the initial investment, also known as the principal, plus any interest earned in the meantime.
- APY is a percentage that represents the amount of interest paid on an account
*and*a consideration of how often the interest compounds. - APY is often used as a measure for the interest earned on investments and deposit accounts like savings accounts, money market accounts, and certificates of deposit (CDs).
- APY is different from the annual percentage rate (APR). APR measures an annual interest rate that does not factor in compound interest and is used for the interest paid on borrowed money.

The main purpose of APY is to provide consumers with a metric that accounts for the compounding of interest. Interest can compound anywhere from continuously to annually. Interest that does not compound at all is called simple interest.

Different types of accounts may have different compounding schedules: some compound interest monthly or quarterly, while others compound daily. Some accounts even compound continuously, though that’s uncommon.

APY is used to calculate the rate of return, as opposed to the interest rate owed on a loan or a credit card (APR). Financial institutions use APY for bank accounts that bear interest; likewise, brokerage firms tend to calculate the interest earned on investments as APY. Be sure to note whether an interest rate is calculated as APY before opening an investment or deposit account.

The formula for APY is (1 + interest rate/compounding periods) ^{compounding periods} – 1.

For example, for an account that bears an interest rate of 5.00% that compounds monthly, the calculation would be (1 + 0.05 / 12)12 – 1.

Even if the interest rate is 5%, the APY for that account is 5.12% — a number that’s marginally higher because it factors in the compounding schedule for the interest borne on the balance. For a hypothetical balance of $10,000, the interest earned on that account over the course of the year would be $512 — an additional $12 because of compound interest.

Some investments may compound continuously. Those accounts have a different calculation for their yield: the value at time t = the principal sum x interest rate x time. “e” is approximately 2.7182, a mathematical constant is known as Euler’s number.

Compound interest works by periodically adding interest to the balance, even if the account holder doesn’t deposit or withdraw money during that time. If money is deposited or withdrawn, the earned interest is still paid out to the account on the compounding schedule.

For example, let’s say you open an account with $100 and it has a 5% interest rate that compounds monthly. At the end of the first month, you’ll have $105; at the end of the second month, you’ll have $110.25. That’s because the 5% interest in the second month applies to your newest total of $105 — not just your beginning investment of $100. Over time, you’ll earn more and more money in the form of interest each month, even if you don’t make any further deposits.

Over the long run, compound interest can boost returns significantly. Because APY is the standard for interest rate numbers on investments and deposit accounts, simple annual interest is relatively rare. But compound interest earns more than a simple annual interest rate calculated on the initial deposit. Depending on the interest rates, compounding schedule, and time horizon, the difference can be quite significant.

APR is an interest rate that does not factor in compound interest, unlike APY. It often measures the yearly interest charged to borrowers for personal loans or credit cards. APR is calculated differently from APY and doesn’t add the effects of compounding on the marginal interest rate charged each period. Essentially, APR is the average annual cost to a borrower (and it can include fees beyond the interest rate, depending on the lender).

Comparing APR rates across lenders can give borrowers a good idea of what they’d be spending in addition to the initial balance of the loan, just like comparing APY rates across investments can give investors a good idea of what they’d earn on those investments as a percentage of the principal. But since APR and APY measure different things and are calculated differently, they’re not interchangeable numbers.

MagnifyMoney has compiled lists of the best high-yield savings accounts, high-yield checking accounts, and CD rates, which track the best APYs offered on those types of deposits. High-yield accounts are designed to provide account holders with the best possible interest rates.

As of 2021, the interest rate environment has been consistent throughout the pandemic: Because the Federal Reserve has dropped the federal funds rate to near zero, the interest borne by deposit accounts has steadily decreased to fairly low APY rates.

APY is calculated as (1 + interest rate/compounding periods) ^{compounding periods} – 1.

MagnifyMoney has a compound interest calculator that can help you determine the interest borne on an account if you have information like the rate of return and the value of the principal balance.

Source: https://www.magnifymoney.com/blog/banking/what-is-apy/

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