Definition, formula, how it’s calculated
- Annual Percentage Yield (APY) is the rate of return you earn over one 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 initial balance plus any interest previously earned.
- The APY on a deposit account changes depending 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 get rich 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 return.
What is an annual percentage return?
An APY is what you will earn on interest on a deposit account over the course of a year. It is common for consumers to earn APY through deposit accounts such as savings accounts, certificates of deposit (CDs), and money market accounts. An APY is always expressed as a percentage and is what you will earn on the funds you keep in your account throughout the year.
“It is generally assumed that the investment should be held for 365 days,” says Laura Lonie, CPA and financial coach at Laura J. Lonie LLC. Lonie adds that this is useful when consumers are comparing various CDs or deposit accounts because 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 on an account during a year. It includes your interest rate and your compound interest, or what you earn on the principal amount plus 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 interest amount because interest is compounded more frequently on the one-year term account” , explains Lonie. “Because APY annualizes 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 may see APY in products such as savings, checks, CDs and
. These are all considered deposit-type investment accounts.
How to calculate APY
To get a better idea of how APY works, let’s take an example. Here is the formula for APY:
Say, for example, you deposit $1,000 on a 12-month CD offering an APY of 5%, compounded monthly.
Using the equation above, here is what is broken down:
(1 + 0.05÷12)12 – 1
(1.0041666666667)12 – 1
1.05116 – 1
$1,000 x 5.116% = $51.16 total interest earned.
The total amount of the account at the end of the year is $1,051.16.
Is the APY variable?
The type of APY you have depends on the financial product you have, although many offer a fixed APY. Some products like CDs offer fixed APYs while savings accounts have variable APYs.
All accounts with a variable APY generally see rates go up and down with market interest rates. So when the Federal Reserve raises or lowers its target interest rate, floating rate accounts usually follow.
“APY can be fixed or variable, but most savings and
vary,” says Lonie. “Interest rates change depending on the economy and the actions of the
. Certificates of deposit are at a fixed interest rate for a fixed period.
APY vs interest rate
APY and interest rates overlap, but they are different. While the APY represents what you can earn on a deposit account, the interest rate alone generally represents what you are charged for a car loan, credit card, or mortgage.
“The interest rate does not take compound interest into account, and the APY includes
loans and the APY for deposit type accounts.”“, Lonie explains. “The interest rate is generally used for
An 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 known as a coupon payment – that represents the amount you will earn each year until the bond matures.
APY versus APR
APY and APR both use interest rates in their calculations, but APY uses compound interest, where you get interest on the principal amount and the earnings. APR doesn’t have that.
“APY includes interest earned on interest while APR uses the simple interest method,” says Lonie. “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, such as savings or money market. The higher the APY, the higher the yield. Use it when shopping for products that feature APYs.