What Is APY? (And Why It Is Important When Making Financial Decisions)
APY is short for “Annual Percentage Yield,” which is the interest you earn by putting your money into an account.
When you invest in a savings instrument, you encounter two interest-related numbers: The nominal interest rate and the APY.
The issuer, such as a bank, credit union, or another financial institution, values the nominal interest rate, but for you as an investor, APY matters most. APY reflects your actual earnings on the investment, factoring in net interest and dollars.
Typically, APY is higher than the nominal interest rate, making it the crucial rate to consider when making investment decisions.
Below, we demystify the concept of APY. If you’ve ever come across this financial term and found it confusing, we’re here to simplify APY, explain its significance, and how it relates to your financial well-being.
KEY TAKEAWAYS:
- APY Defined – APY, short for Annual Percentage Yield, is what you will earn on interest on a deposit account over the course of a year. APY is a crucial metric for evaluating the true earnings or returns on your savings or investments.
- Fixed or Variable – APY can be fixed or variable, meaning rates may stay the same for a set time or fluctuate.
- Comparing and Maximizing APY – Knowing how to compare APY across investments and manage risk can help you make informed financial decisions.
Calculating APY
At its core, APY is a way to express the annual interest rate you earn on an investment, considering compounding interest.
It considers how your money grows not just from the initial interest but also from the interest on interest, creating a more accurate reflection of your earnings.
The mathematical formula for APY is:
APY = (1 + r ⁄ n) n – 1
Where:
- r represents the nominal interest rate (expressed as a decimal).
- n signifies the number of times that interest is compounded per year.
Don’t worry if this looks a bit complex; in practice, financial institutions and online calculators handle these calculations for you.
You don’t need to be able to memorize that formula; understanding the concept is what matters.
What APY Can Tell You
APY provides a clear picture of how your money can grow over time when compounding is considered. It’s particularly useful when comparing different savings or investment options.
Ignoring the effect of compounding may give inaccurate expectations for vital financial milestones.
A higher APY generally indicates more favorable terms for you. So, when you see two financial products offering similar nominal interest rates, check their APY to identify the one that will help your money grow faster.
How to Check for APY in Your Accounts
Financial institutions are required to provide information about the APY, as well as details regarding fees and interest, in compliance with regulations such as the Truth in Savings Act (Federal Reserve Regulation DD).
This information should be readily available to customers when opening their accounts. You can refer to the documentation you received during your account opening process, which may contain the account’s APY.
If you can’t locate this information, are unsure about your interest rate or compounding frequency, or prefer assistance with the calculations, your financial institution is usually able to help.
APY vs. APR: What’s the Difference?
It’s important not to confuse APY with APR (Annual Percentage Rate) when comparing different financial products.
While APY focuses on the earnings and growth of your interest-bearing investments (High-yield savings accounts, CDs, etc.), APR is used to calculate the cost of borrowing, such as personal loans, auto loans, and credit cards.
Consumers sometimes mix up the two because both lead to an effective interest rate, which typically differs from the nominal rate.
Basically, APR is what you owe, and APY is what you earn.
Variable APY vs. Fixed APY
In your journey to explore APY, you may encounter variable and fixed APY.
Understanding the pros and cons of both types will help you make informed decisions, especially when considering long-term investments or savings goals.
Variable APY: This means that the interest rate can change over time based on market conditions. It offers flexibility but can lead to uncertainty about your future earnings. Variable APY is frequently found in interest-bearing checking, savings, and money market accounts.
When the Fed Reserve lowers its benchmark interest rate, you can generally expect the APYs of these accounts to follow suit with decreases. Conversely, when the Fed raises its benchmark rate, as it has done multiple times in 2023, you’ll often see those APYs increase.
Fixed APY: With a fixed APY, the interest rate remains constant throughout the investment’s term. This provides predictability and stability in your earnings. Certificates of Deposit (CDs) serve as a typical example of a fixed APY.
CD terms, including the interest rate and compounding frequency, remain constant until the CD reaches maturity. Once the certificate is established, it represents a binding agreement between the investor and the bank and remains unchanged unless the CD’s terms explicitly allow for modifications.
What is a Good APY Rate?
APY rates are subject to frequent changes, meaning the assessment of a “good” APY can evolve accordingly. To gauge whether an APY is favorable, a reliable method is to compare it with FDIC’s National Rates and Rate Caps list.
For instance, as of September 18, 2023, the average savings account rate stood at 0.45 percent. Therefore, any rate surpassing this benchmark would qualify as an above-average APY.
APY and Risk: What’s the Relation?
It’s essential to consider risk when evaluating investments with different APYs.
APY varies based on the type of savings product and its associated interest rates.
Checking accounts typically offer the lowest APY due to the high flexibility of fund withdrawals, which increases risk for the bank and results in lower interest payouts.
Savings accounts and money market accounts generally provide higher APYs since funds are less frequently withdrawn, reducing risk. These accounts are often used for longer-term savings, allowing banks to offer more competitive rates.
The highest APYs are found with CDs because funds are held for specific periods, minimizing risk and enabling banks to set higher interest rates. Longer CD terms also yield higher rates, as they offer even greater predictability and lower risk.
While it’s tempting to chase the highest APY, it’s equally crucial to assess your risk tolerance and financial goals. A balance between risk and reward is key to building a diversified portfolio that aligns with your financial objectives.
Closing Thoughts About “What is APY?”
In conclusion, APY is a powerful tool for understanding the growth potential of your investments.
We encourage you to keep an eye on APY when making financial decisions and consider the importance of risk management.
Remember that achieving your financial goals takes time, patience, and informed choices.
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