You’ve probably heard the term “annual percentage yield” used a lot when it comes to credit cards, loans and mortgages. Banks or investment companies use the annual percentage yield, or APY, to calculate how much your investment will earn in interest over a year. Since each bank’s APY rates will differ, it’s important to understand how to calculate them to make the best investment decision.
This article will explain what APY is, why it’s important to understand, and how it affects your banking or investment decisions. This way, you can start calculating APY rates on your own using formulas, online tools and other resources to know exactly how much your savings or investment will earn.
What Is APY?
The annual percentage yield, or APY, is the rate at which your investment will earn money over the course of a year. They often apply to funds deposited into a savings account, a checking account or any other account that earns interest over time.
The APY rate considers the total interest earned on your investment, including compound interest. Compound interest is the interest earned on both your investment and your total earnings over time. So, the higher the APY rate, the greater your total earnings.
Since most accounts earn interest regularly, such as annually, quarterly or once per day, the total annual earnings can vary depending on their interest rate and how many times it compounds annually.
Suppose you have a yearly interest-bearing account. This means that the account will only pay interest once a year. On the other hand, an account that earns interest monthly or daily will pay out interest more frequently.
You might want to choose an account with a high-interest rate. However, if it only compounds a few times per year, you may earn less than if you chose a lower interest rate that compounds more frequently.
This is why the APY rate is so important: It considers all the varying interest rates, compounds the total earnings per year and gives you a clear picture of the amount you’ll make in a year.
How Is APY Calculated?
So, how is the APY calculated? As you might expect, compounding the exact return on investment over a year can be tricky. This is why banks and investment firms use the APY formula to calculate your total annual earnings.
To calculate the APY rate, you’ll need the interest rate and the number of times the interest rate is compounded yearly. Most investment accounts publicize their interest rate policies, making it easy to look them up and calculate your APY rate.
Sounds challenging? Not to worry, plenty of resources are available to help you calculate your APY rate.
How to Calculate the APY Formula
First, we’ll explore some quick math and figure out how to calculate the APY formula. Feel free to grab a pen and paper and give it a shot.
The APY formula for calculating total earnings on an investment account is as follows:
APY = (1+r/n)n – 1.
The letter “r” represents the annual interest rate of your account, while the letter “n” represents the number of times your interest rate compounds each year.
To better understand the APY formula, let’s look at an example. Say you want to invest in an account with a 2% interest rate that compounds every three months. You’ll insert the interest rate in place of “r” in the APY formula as a decimal. The decimal value of 2% is 0.02.
Next, replace “n” with “4” because interest compounds four times, or every three months, in a year. Once done, the APY formula should be as follows: APY = (1+0.02/4)4 – 1. When you plug this equation into a calculator, you should get an APY rate of 0.02015%.
Let’s assume you put $1,000 in the account. This is known as the principal balance. To figure out how much you’ll make in a year, calculate your total earnings with the following formula:
(APY * principal balance) + principal balance = total earnings.
When you plug these figures into a calculator, you should have (0.02015% * $1,000) + $1,000, which equals $1,020.15.
Though a $20.15 increase may not seem like much, if you choose an account with a higher compounding period per year and a higher interest rate, you’ll get a higher APY rate that gives you more earnings over time.
How to Use Online APY Calculators
Alternatively, plenty of online resources can help you easily calculate APY rates. Simply search “APY calculator” to access online tools that calculate total interest over a year.
To use online APY calculators successfully, you’ll need to obtain the following information from your investment agent or official investment account communication channels:
- Interest (nominal) rate
- Initial (principal) balance
- Investment term or time period
- Compound frequency
Some calculators allow you to enter the deposit amount and frequency if you intend to make regular deposits. Once done, the online APY calculator can display the APY rate and the expected final balance at the end of the investment period.
Why Does APY Matter in Banking or Investment Decisions?
The APY rate gives you a more accurate picture of how much you’ll earn per year. Sometimes, interest rates may seem high. However, your earnings may only compound a few times a year to earn a lesser income.
So, when making banking or investment decisions, or taking out a loan, compare APY rates across several investment options. Whether it’s a certificate of deposit, a stock or a government bond, the APY rate ultimately determines the exact earnings per year, allowing you to make an informed decision.
Additionally, a good APY is always one with a higher rate. Overall, the higher the APY rate, the greater your potential earnings, provided the transactional fees and extra charges remain constant.
