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What is APY? Annual Percentage Yield Definition and How It Works
When you invest your hard-earned money in an instrument, you will commonly see two figures representing the interest payment on your account: APY and interest rate. While the interest rate is the nominal rate of interest you receive on your investment, APY stands for Annual Percentage Yield, which is more crucial to understand. To understand which figure is more relevant to your investment, you must understand the APY meaning in detail. Here’s a brief overview.
What Does APY Mean?
If you want to open a savings account, you must be wondering what is APY meaning in banking and how vital it is. Well, APY means the actual rate of interest you receive from depositing your money in an account in a period of 12 months. The accurate projection of the returns largely depends on the impact of compounding interest and the frequency of interest payment. Assuming you do not withdraw any money from your account, it accounts for how the interest adds to the principal amount and increases your return rate.
Interest rate measures the paid returns within a duration, and a simple interest account only pays interest on the principal deposited amount. On the other hand, a compound interest account pays interest on the principal and any previous accrued interest. Therefore, an account with an interest of 1% with annual compounding earns less than a similar account with monthly compounding.
Formula to Calculate APY
APY uses a mathematical formula to combine interest rates and the frequency of application. Understanding what an APY account means and the formula to calculate it clarifies how the account’s APY affects the money present in it. The formula to calculate APY is as follows:
APY = (1+r/n)n-1
To calculate the APY, you must start with two variables: interest rate and the number of times the interest compounds in 12 months. Input these variables in the formula. For instance, if your account generates 2% interest monthly, the formula would be as follows:
APY = [1 + (.02 / 12)]12-1
When you calculate, the result will be
= [1 + 0.0017]12-1
= [1.0017]12-1
= 1.0202-1
= 0.0202 or 2.02%
If you want to skip the math, use a compound interest calculator to calculate the APY quickly and more accurately without any chance of error.
How APY and Interest Rate are Different?
To clearly understand the APY meaning in banking, you must know how it differs from interest rate. Here is an outlook:
| Parameter | Annual Percentage Yield | Interest Rate |
| Meaning | Reflects the total interest you earn on the principal amount deposited in your account in a year. | Reflects the interest rate at which you earn returns on the principal amount. |
| Inclusion | Includes interest you earn on your original balance and the amount of compound interest you make in a year. | Only accounts for the interest you earn on the original amount. |
| Calculation | Uses a standard formula that considers the interest rate, compounding frequency, and investment length. | Calculates as a percentage of the deposit amount. |
| Basis | The higher the frequency of compounding the interest, the higher will be the APY. | The interest rate can be fixed or floating depending on the investment and account type. |
Also Read: APY Vs. APR: Know The Difference?
Key Differences Between APY and APR
Here’s the APY vs APR comparison:
| Parameter | APY | APR |
| Full Form | Annual Percentage Yield | Annual Percentage Rate |
| Meaning | When you talk about APY, it is the interest you earn on your investment account. | When you talk about APR, it is the interest amount you pay towards a borrowed loan. |
| Examples | APY Example: savings accounts, investments in securities, fixed deposits, etc. | APR Example: mortgage loans, personal loans, housing finance, etc. |
| Fixed or Floating | APY depends on the frequency of compounding. | APR can be fixed or floating depending on the loan type you borrow. |
| Preferable APR or APY | A higher APY is better, as it means higher interest earned on an investment. | A lower APR is better, as it means a lower interest cost for borrowing a loan. |
| Impact of Credit Score | A credit score does not impact your APY, as financial institutions have fixed APYs for their investment products. | Lenders consider your credit score when calculating your interest rate. |
Conclusion
Understanding APY's meaning can help you get a clear idea of what you will earn on your savings by considering the compound interest. It will help compare different investment avenues to see your money stack up. On the other hand, use a loan EMI calculator to calculate your interest rate for a Personal Loan and determine the total loan cost. Both the calculations will help you save money and enjoy the benefits.
Frequently Asked Questions
1. What does 4% APY mean?
4% APY means you will earn 4% returns on your investment amount in a year.
2. How is APY calculated?
Calculate APY using this mathematical formula: APY = (1+r/n)n-1.
3. What is a good APY?
Anything above the national average is a good APY to earn. Aim for an APY of more than 5%.
4. What is an example of an APY?
If you deposit Rs 100 for a year at 5% interest and the compound interest is calculated quarterly, you will accumulate Rs 105.09 at the end of the year.
5. How do you calculate monthly interest on APY?
Divide your APY by twelve to find the interest percentage earned per month.
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