When you invest in a product, you expect a return above and beyond what you paid for that product. This is APY. What is APY? It stands for annual percentage yield, and it represents the rate of return on an investment. APY takes into account compounding interest payments over the course of a year. It’s typically used to show the prospect of short-term investments that compound monthly (or more frequently). The smaller the time between compounding, the higher the APY.

APY exclusively refers to investment yield; however, it’s the same concept as effective annual rate (EAR), which is the actual interest paid to a creditor by a borrower. APY is an important concept for understanding the viability and lucrative potential of a short-term investment. Here’s what you need to know. 

How Does APY Work?

APY factors everything into a fixed investment to show you the real rate of return. This means APY accounts for fees and other expenses, and it assumes you don’t add or withdraw funds between compounding periods. The higher the APY, the better. 

Different types of financial products can carry fixed or variable APY. Something like a savings account will offer a variable APY, which can rise or fall depending on the fluctuating interest rate offered by the bank. Something like a bond or a certificate of deposit will have a fixed APY. This means the annual percentage rate (APR) will stay consistent for the term of the investment, thus resulting in a fixed APY. 

Whether fixed or variable, regardless of product, APY works by measuring the compounding value of the principal balance. For example, if you deposit $100 in an account that offers an APR of 12%, you gain 1% per month in interest. If that interest compounds, the principal balance grows by slightly more than 1% each month, resulting in the APY. 

How to Calculate Annual Percentage Yield

As mentioned above, the formula for APY is generally the same as the formula for EAR. To calculate APY, follow this equation:

APY = (1+r/n)n-1

• r = the period rate
• n = the number of compounding periods

From the equation, it’s easy to see that the more compounding periods there are, the higher the return. For example, consider a $1,000 fixed investment at 5%, compounded quarterly. At the end of the year, after four compounding periods, you’d have $1,050.95 at a 5.095% APY. Now take this same amount and compound it quarterly over five years: It becomes $1,282.04. 

The Difference Between APR, APY and Nominal Interest Rate

There’s often a lot of confusion surrounding the difference between APR, APY and nominal interest rate. While these three concepts often work in tandem, they’re very different in terms of the information they provide to investors. Here’s what each means:

• Nominal interest rate. This is the annual interested generated by the principal balance. It doesn’t account for any additional costs or fees. 
• Annual percentage rate (APR). This is the annual interest generated by the principal balance, including costs and fees, expressed as a percentage.
• Annual percentage yield (APY). This rate factors in compounding to provide investors with a glimpse at the rate of return on an investment over the course of a year.

Generally, banks and other financial institutions will advertise products by their APR or APY – whichever offers a more lucrative return prospect for investors. To help distinguish between them, the Truth in Savings Act of 1991 mandates that institutions disclose both figures, so investors can compare them equally across products. 

It’s also important not to compare APR with APY when evaluating products. Comparing APR with APR doesn’t work either, since it ignores the effects of compounding and doesn’t look ahead to total ROI. Instead, compare APY with APY across like-kind products, to get a clearer sense of return prospects. 

APR vs. APY: A Matter of Perspective

Most often, APR comes up in the context of debt accounts: credit cards, mortgages, loans, etc. Conversely, APY is the measure of return in savings vehicles, like checking and savings accounts, money markets, CDs, etc. This has to do with the language surrounding interest rates. If you’re the borrower (debt account), APR represents the interest rate you’ll pay, which tends to be the more important factor to consider. For lenders, APY is the more important variable: You want to know what your return will be. 

APR and APY apply to both sides of the coin; it’s just a matter of perspective as to which interest-related metric is more important. 

How Can Investors Use APY to Their Advantage?

APY is a great tool for evaluating short-term investment products. It’s more telling than APR in many cases, because it accounts for compounding. For example…

Marvin is trying to decide between a zero coupon bond that pays 6% at maturity and a CD that pays 0.5% monthly, with compounding. The APR of both products appears the same (6%). However, the compounding rate of the CD makes this a more lucrative investment because the APY actually comes out to 6.17%.

APY allows investors to make a more informed decision about where to invest in short-term vehicles. Including compounding in the equation provides more insight than APR is able to offer at a surface level. 

The Bottom Line on Annual Percentage Yield

What is APY? If you’re a short-term investor, APY is a valuable tool in helping you understand the expected return on your investment and for comparing like-kind products. It’s also an important metric alongside APR in evaluating different products for borrowers and investors alike. Ultimately, it’s a way to assess the power of a compounding investment. In a nutshell, APY is exactly what you should be looking at if you’re trying to maximize short-term returns.

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