Annual percentage yield (APY) calculates the actual return on investment after one year. The measurement includes compounding, which is why it's commonly used to compare investments of different compounding frequencies.
Otherwise known as the "effective annual rate" (EAR), APY is commonly confused with the annual percentage rate (APR). APY/EAR and APR differ because APR does not consider compounding.
Additionally, APY is only accurate for one year. Any calculation beyond that may not consider changing interest rates or compounding frequencies. In those cases, it's best to recalculate APY each year to ensure you are getting the most accurate return on investment.
While you can easily use our APY calculator above, we've included more information below for those interested in learning more about how to calculate APY and real-world examples.
How to Calculate APY
As previously mentioned, APY calculates the real rate of return when including compound interest. This is the primary difference from calculating APR. Investors prefer a higher APY because it yields a higher return. The formula to calculate APY is:
- r = Annual Interest Rate
- n = Number of annual compounding periods
The calculation results in your annual investment yield when accounting for compounding. You can then use this yield to estimate your investment balance in one year accurately. The following subsection will dive deeper into the inputs used to calculate APY.
Interest Rate (r)
The interest rate used in the APY formula is the annual interest rate provided by your investment. This is offered to you by the investment company and typically ranges around 1.00% for deposit accounts in the United States. Note that APY assumes a fixed 1-year interest rate.
A higher interest rate will increase your APY and investment return.
Compounding Frequency (n)
Compounding frequency is the number of times interest payments are applied to an investment's balance per year. This can range from daily to annual compounding. The value of n will change with depending on how many compounding periods you have in a year:
- Daily - 365
- Weekly - 52
- Monthly - 12
- Semi-Annually - 6
- Quarterly - 4
- Trimesterly - 3
- Yearly - 1
This allows the investment's earnings to grow on a compounded basis, which can result in a higher return over time. For example, if compounding occurs monthly, the compounding frequency would be 12.
The formula assumes all interest distributions are reinvested. As a result, a higher compounding frequency will increase your APY and investment return.
Let's use APY to compare the actual return for two investments of varying interest rates and compounding frequencies.
|Investment One||Investment Two|
|2. Calculating APY|
= (1 + 0.02/12)^12-1
= (1 + 0.02/4)^4-1
|3. Closing Balance|
= $10,000 * (1 + 0.02018)
= $10,000 * (1 + 0.02015)
As you can see, a more significant compounding frequency with the same interest rate results in a higher investment yield. This is because more frequent compounding allows for accumulated earnings to grow at a faster rate.
Once you've calculated APY, you can determine your investment balance in one year. However, the formula assumes that only one lump-sum contribution is made, and all interest distributions are reinvested. For example, we can calculate the future value of the two investments in one year. Above shows that a higher APY results in a more significant closing balance after one year.
APY vs. APR
APR and APY are often used interchangeably, but they have important distinctions. APR is the annual percentage rate and only considers the investment's interest rate. It does not factor in compounding, which may result in a lower return estimate than APY. APR assumes interest distributions are not reinvested.
APY includes compounding and provides a more accurate estimate of the investment's actual return. It is essential to use APY when comparing investments and estimating future balances. However, if the investment compounds annually, then APY and APR will equate.
In summary, APY is a helpful tool for calculating the annual yield of your investments. It considers interest rates and compounding frequency to give you a more accurate estimate of your investment return.