Have you ever watched banks quoting the “APYs” and wondered what it actually meant? Banks are necessarily required to display the rate for their deposit accounts, like savings accounts and certificates of deposit (CDs). It gives you the most accurate idea of what your money could earn annually to compare the returns on different deposit accounts.
The annual percentage yield (APY) is the rate of return earned on an investment considering the effect of compound interest, which is the interest you earn on your principal plus the interest on your earnings.
Distinct from simple interest, compound interest is calculated period wise and the amount is added to the balance. As the period moves further, the account balance gets a little increment, so the interest paid on the balance becomes major as well.
The more is the interest compounded, the higher the APY. To make it Simple it indicates the total amount of interest you earn on a deposit account over one year, assuming you do not add or recede funds for the entire year.
How Is APY Calculated?
APY Standardizes the rate of return by simply stating the real percentage of growth that will be earned in compound interest assuming that the money is deposited for one year. The formula for calculating APY is (1+r/n) n - 1), where r = period rate and n = number of compounding periods.
Variable APY vs. Fixed APY
APYs can be affiliated with variable or fixed-rate deposit accounts. A variable APY fluctuates and changes frequently with macroeconomic conditions, typically savings or money market accounts (MMA) meanwhile a fixed APY does not change (or changes much less frequently, during the term of the account.
Some banks also offer different APYs depending on the balance levels. This means you may earn a different APY based on the amount of money in your account. For example, you might get a higher APY for higher account balances.
Difference Between APY and APR?
APY is somewhat similar to the annual percentage rate (APR), but the latter is used for loans. APR tells you how much it costs to borrow money over a year and applies to a variety of credit accounts, including mortgages, credit cards, home equity loans, and personal loans.
APY calculates the compounded rate earned in one year and is a more precise depiction of the actual rate of return. APR includes fees or additional costs inter-connected with the transaction, but it excludes the compounding of interest within a specific year, which means it is just a simple interest rate.
The Bottom Line
As argued by the calculations of simple interest, APY accounts for the compounding effect of prior interest earned generating future returns. And this is the reason why, APY will often be higher than simple interest, especially if it is compounded.
So, what does this all mean for your Finances?
APY is arranged to help consumers compare deposit accounts. Simply put, the higher the APY, the more you can earn and the faster your bank account balance will grow. The APY Standardizes many components related to the interest calculations on deposit accounts (for ex. Compounding frequency) so consumers can make better comparisons between different deposit accounts and don’t get caught up in the uncalled details. This can help you make comparisons based on your initial investment, monthly contributions you plan to make, the period you keep in the account, and its compounding frequency.
After all, any investment is eventually adjudged by its rate of return, whether it's a certificate of deposit (CD), a share of stock, or a government bond. The rate of return is only the percentage of growth in investment over some time, usually one year. But rates of return can be complex to equate across different investments if they have different compounding periods. One may compound daily, meanwhile, another may compound quarterly.
Comparing rates of return by simply stating the percentage over the period may give an incorrect result, as it may ignore the effects of compounding interest. It is crucial to know how often that compounding occurs because as more often a deposit is compounded, the faster the investment growth. This is because every time it compounds the interest earned over that period it is added to the principal amount and future interest payments are calculated on that particular larger principal amount.
The Risk with APY
In general, investors are usually complimented higher returns when they take on greater risk or agree to make sacrifices. The same is the case concerning the APY for checking, saving, and certificate of deposits.
When a client holds money in a checking account, He is asking to have the money on demand to pay for the expenditure. At a given notice, the Client may need to withdraw their debit card, buy groceries, and draw down their checking account. This is also the reason, checking accounts often have the lowest APY because there is no risk or sacrifice to the consumer.
When a consumer holds money in a savings account, the consumer may not have an instant need. The consumer may need to vest the funds in their checking account before using it. Electively, you cannot draw checks from normal savings accounts. This is the reason; savings accounts usually have higher APYs than checking accounts because consumers face greater boundaries with savings accounts.
Also at the end, when consumers hold a certificate of deposit, he is agreeing to sacrifice liquidity and access to the funds for higher return in APY. The consumer can't expense the money in a CD (or they can after paying a penalty to break the CD). This is the reason, the APY on a CD is the highest of the three above as the consumer is being rewarded for surrendering immediate access to their funds.
Consider the example where the Rs100 investment yields 5% compounded quarterly. During the first quarter, you earn interest on the Rs100. However, during the second quarter, you earn interest on the Rs100 as well as the interest earned in the first quarter.
Does that mean a good APY Rate?
The rates of APY Snap very often, and a good rate at one time may no longer be a good rate at another time due to changes in macroeconomic conditions. In general, when the Federal Reserve increases the interest rates, the APY on savings accounts also tends to increase. Therefore, APY rates on savings accounts are usually better when monetary policy is tight or tightening. In addition, there are also various low-cost with a high-yield savings account that regularly delivers rival APYs.
How is APY an aid to the Investor?
Any investment is ultimately judged by its rate of return, whether it's a certificate of deposit, a share of stock, or a government bond. APY allows an investor to compare different returns for different investments on an equivalent basis, allowing them to make a more sensible decision.