The Annual Percentage Yield or APY is the effective annual rate of interest that is earned including the effect of compounding. When compounding is not considered it is referred to as the nominal interest rate or simple annual interest rate.
The APY is expressed as an annualized rate, based on a 365-day year
The annual percentage yield is greater than the periodic interest rate multiplied by the number of periods (because it is compound).
The APY is a standardized method for calculating compounded interest earned on an investment or deposit account.
The annual percentage yield is similar in nature to the annual percentage rate or APR, which is used for loans and states the total borrowing costs – including all fees – as a single number expressed as a percentage.
Both the APY and APR are standardized measures of interest rates. However, the APY considers only compounding periods and not account fees. It is useful in that it standardizes several interest-rate agreements into one annualized percentage figure.
APY refers to the yield that the customer receives, while the APR refers to the yield that the bank (lender) receives – it is the other way round.
To promote financial products and other investments that do not involve debts, financial institutions will typically quote the APY – as opposed to the APR. A CD (certificate of deposit), for example, that has a 4.65% APR, compounded monthly, for eight months would be quoted as a 4.75% APY instead.
Example of annual percentage yield
Imagine you place $1,000 into an account for a period of one year at 1% simple interest (non-compounding). At the end of the year you will have $1,010. The APY is 1% – the same as the interest rate.
Now, let’s suppose that the interest on that account compounds on a daily basis. The total interest you would receive for the year would be $10.05, which would give you a total of $1,101.05 at the end of the year.
In this case, the annual percentage yield is 1.005%.
There are several calculating programs online to help you calculate the APY.
According to BusinessDictionary.com, the annual percentage yield is:
“Standardized method for quoting compounded interest earned on a deposit account or investment. In computing APY, it is assumed the funds will remain on fixed deposit or invested for a full 365-day period.”
Video – What is Annual Percentage Yield?
This video explains the difference between APY and APR.