Understanding the meaning of APY

APY stands for Annual Percentage Yield. So if you're wondering: what does APY mean? This guide has you covered.

We’ll walk through the APY meaning and APY calculation, and look at why APY matters when you have savings or investments. We’ll also look at why a good APY can mean your savings or investments grow.

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What does Annual Percentage Yield (APY) mean?

APY stands for Annual Percentage Yield. It’s a term you’ll see referring to the amount of interest or return you may generate from savings or investments, and can be expressed as a fixed percentage amount, or a variable percentage which can change over time.

We’ll look at how this works in detail next.

What is APY and how does it work?

So now we have a definition of APY — but what does APY mean in banking, and why does it matter?

In short, APY is the annual return on an investment, taking into account the effects of compound interest.

Compound interest is important to investors as it includes the extra returns generated by reinvesting the interest you’ve already earned, and can lead to an exponential growth pattern.

How is APY calculated?

APY is calculated by taking the annual amount you’ll get in returns on a given investment, including the extra yield from the effects of compounding. That sounds a little complicated, but it’s not all that difficult to imagine.

Here’s an example:

Let’s say you have a certificate of deposit (CD) which pays interest every month. In the first month you deposit a fixed amount, and at the end of the period, the interest is paid and added to the account.

In the second month you’ll earn the same percentage interest — but it’ll be derived from a larger deposit, because you’ve got your initial funds plus the interest paid last month. That means the actual amount of interest that you’re paid is higher.

At the end of the second month, this interest amount is added to your initial deposit, and so in the third month, the interest paid is derived from an even larger base amount. This goes on, so that the pattern is one of increasing returns on every period.

It’s worth noting that the rate of APY depends on the pattern of interest payments in the first place.

In this example we’ve used an account which pays monthly, but some accounts accumulate interest daily, every quarter, or annually for example — these factors all impact the annual rate of yield, and so must be weighed up when picking an investment vehicle.

Why is APY important?

You’ll commonly see APY set out on financial products, such as the APY on CDs or other savings accounts. That’s because APY is used to show an annualized yield to help investors compare their options.

APY is important because it standardizes the yield being described to investors. While products and accounts may actually pay interest at different rates — daily, monthly, or annually, for example, by creating an annual equivalent you can compare different options with a level playing field.

When an account pays interest more frequently, it can lead to a higher APY because the compounding effect will start earlier and increase at a faster rate. For example, let’s say you want to compare a 12 month bond which only pays out interest at the end of the term, against a savings account which pays out monthly.

Because the interest on the savings account is paid monthly, you’ll start to see the effects of compounding earlier. The interest you earn from the second month onwards will be based on a higher principal amount, which means that even if the interest rates shown look fairly similar, the APY on the monthly compounding savings account is higher compared to the bond.

Account types that offer APY

We briefly touched on the question — what does APY mean on a CD? — but CDs aren’t the only account type where you’ll see APY used. APY can be used as a means of describing the return on a range of products, including:

Certificates of deposit Bonds Money market accounts Saving accounts and high yield savings products Checking accounts which earn interest

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APY vs. APR: decoding the difference

Whenever you’re dealing with financial products you’ll run into a lot of acronyms. You may therefore have seen both APY and APR shown as a fixed or variable percentage. They do have similarities, but these terms are used in different contexts:

• APY: Annual percentage yield, the annual return paid to the customer by an investment product, taking into account compound interest

• APR: Annual percentage rate, the annual amount a customer who has taken a loan will repay, taking into account both interest and fees

You’ll see APR expressed on products like loans, while APY is used on savings and investment products.

It’s also helpful to note that while APR takes into account the fees a borrower has to pay for a loan, APY does not cover any fees — only compounding interest.

That means that if you have an investment product or savings account which has monthly fees, for example, that these costs aren’t factored into the APY shown.

Learn all about the differences between APY and APR with our full guide

APY example

The formula for APY is:

(1+r/n)n - 1

Where:

• r = period rate

• n = number of compounding periods

Let’s work through that, using the example of an account which pays interest monthly, at 0.3%.

The APY calculation would run as follows:
First, convert the monthly interest rate to decimal form by dividing it by 100: 0.3/100 = 0.003 Add 1 to the monthly interest rate: 1 + 0.003 = 1.003 Raise the result to the power of 12 (since there are 12 months in a year): 1.003*12 ≈ 1.03679 Subtract 1 from the result: 1.036 - 1 ≈ 0.03679

Therefore, the APY for an account that pays monthly interest at a rate of 0.3% is approximately 3.679%.

Things to know about APY

APY can seem a bit confusing — but it’s a helpful concept if you’ve got money to save or invest. Let’s look at a few more important and connected topics you’ll want to know about.

What is compound interest?

Compound interest describes the idea that your savings start to earn interest on top of interest. That means you see an exponential growth pattern in the amount of money you have. Obviously — that’s good news if you’re investing or growing your savings.

The basic idea is that once you make an initial deposit you start to earn interest on a daily, monthly, quarterly or annual basis.

Once a payment of interest is made, it’s added to your initial deposit amount. In the next period you earn interest again — but this time you’re earning on not only your principal deposit, but also on the interest you earned earlier.

The same thing happens each period as long as you don’t make withdrawals, meaning a higher and higher interest earning opportunity each time.

Variable vs. fixed APY

Financial products set out their APY to help customers assess and compare their options. However, one thing that’s important to note is whether the APY being described is fixed or variable.

A fixed APY is guaranteed to remain the same for the investment period. With a CD for example, you may choose to tie in your funds for a year, and in return, the bank will offer a fixed APY for that period. Variable APYs don’t have the same predictability, and can change according to the markets or Federal Bank rates.

Neither fixed nor variable APYs are inherently better — the best one for you depends on your preferences.

APY and loan interest rates

As we’ve seen, APY is used to describe a yield in an investment or saving product. When you’re taking a loan you’ll want to look out for the APR, which is the total repayment percentage including interest and fees.

It’s helpful to note that APY and APR are calculated differently. In particular, the APR calculation takes into account fees but not the compounding effect, while the APY calculation looks at compounding but not fees.

If you’re unsure about the best product for your needs it’s useful to compare a few options and take professional advice.

APY and risk

Before you choose any financial product it’s important to make sure you understand the risks involved. Savings accounts held with reputable organizations, banks and credit unions should offer protections and limit the amount of risk you’re exposed to. However, you’ll need to double check before signing up for any specific product, and take advice if needed.

APY FAQ

What factors can affect APY?

APY is set according to the annual amount of yield a savings or investment product can bring. Factors affecting the APY available on different products can include market forces, Federal interest rates, and bank or provider policies and promotions.

Is a higher APY always better?

A higher APY suggests a better annual yield on savings. However, you’ll also need to consider other factors such as any applicable fees or penalties, and how long you’re required to invest your funds, to decide if it’s a better option for you.

Generally, before choosing any specific savings or investment product, you’ll want to weigh up a few options and take the advice of a financial advisor if you’re unsure.

How does APY impact your savings?

APY is the annual percentage yield on a savings product, taking into account the compounding effect. That means that a higher APY can mean you get more from a savings account, as long as you leave your funds untouched for as long as possible.

Can APY change over time?

An APY can be fixed or variable. Fixed rates can be set for a certain period, or will change only infrequently, and with notice to investors. Variable APY rates change more frequently in line with changes in the market.

What is a good APY rate?

APY rates change frequently according to changes in the market and the way that overall interest rates move. To see what’s a good rate at any given time, you’ll need to compare a few products to get a feel for the best available.

How can APY assist investors?

APY is a handy measure for investors as it allows comparison of returns on products which pay interest at different frequencies. You can use APY to compare an account with monthly interest versus a bond with annual interest, for example.