What Is APY and How Does It Work?

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APY, or Annual Percentage Yield, is an important term to understand if you want to maximize your money’s growth potential. It measures the interest earned on a financial product or account over one year. The higher the APY, the faster your account will accumulate interest.

Knowing how to calculate APY and how it affects your investments can help you make informed decisions about where to invest your money.

What Is APY?

APY is a formula used to calculate the amount of interest earned on an investment or savings account over one year.

Though it is often used interchangeably with the term “yield,” there are some critical distinctions between the two. For one, APY takes the effect of compounding interest into account.

This means that your money earns interest not only on the principal investment, but also on the interest you’ve already earned. Since your account balance will get bigger each month from the added interest, the interest paid on this balance will increase as well.

How Is APY Calculated?

Use the following formula to calculate APY manually. If you need to know your interest rate, you can ask your bank or credit union for the information. For credit cards, check your monthly statements.

How To Calculate APY

APY = (1 + r/n)ⁿ – 1 

r = interest rate

n = number of compounding periods — daily compounding interest would be 365

When calculating APY for a compound interest account, you need to consider the number of compounding periods. For example, a typical interest account will have interest calculated once per year, but some accounts will calculate interest multiple times per year. You can find the APY of your account by multiplying the stated interest rate by the amount you have in the account.

For example, suppose you have $5,000 in a CD account with a 3% interest rate. If it’s compounded monthly, the formula will look like this:

APY = (1 + 0.03/12)¹² – 1

APY = 3.04%

To find out how much money you’d have at the end of the year, multiply your initial deposit by the APY. In this case, your final account balance would be $5,152.08.

How Does Compound Interest Work?

Compound interest is the interest you earn on all the money in your account — not just the principal deposit, but also the interest itself. This distinguishes compound interest from simple interest, which is the interest you earn on the deposit only.

Compound interest works on a schedule. It can compound in different increments, including daily, monthly, quarterly and annually. With APY, the money earned in interest is annualized over the course of a year. Because it acts as a money multiplier, compound interest is one of the best ways to grow your savings.

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Let’s say you have $10,000 in a high-yield savings account and earn 5% interest on this money. By the end of the year, you will have made $500 in interest and have $10,500 in your account. This might not seem like a huge sum, but compound interest builds over time.

If you keep that $10,500 in the same account the following year, you’ll earn the same 5% interest rate but on the new amount of $10,500 rather than the initial $10,000. This means that you will have $11,025 in your account at the end of the second year. By the end of year three, you will have made a total of $1,577 in interest alone.

Variable APY vs Fixed APY: Understanding the Differences

APY can be variable on some financial products like checkings and savings accounts. However, other financial products, such as certificates of deposit, offer a fixed APY.

Variable APYs generally respond to rising or falling market interest rates. These benchmark interest rates are set by the Federal Reserve. Thus, when the Federal Reserve raises the benchmark rates, variable APYs tend to rise, and when they decrease the benchmark rates, variable APYs will also decrease.

It’s important to note that one type of APY is not inherently better or worse than the other. However, they do serve different purposes, and it’s important to understand what you’re getting into when you choose one over the other.

A variable APY can work to your advantage as a saver if interest rates are poised to go higher. For example, when the Fed cut interest rates to near-zero in response to the coronavirus pandemic, that would have been a good time to pick up a variable-rate savings account, as APYs had nowhere to go but higher. But as of mid-2024, when savings rates in many cases exceed 5% and the Fed seems ready to begin trimming interest rates, it might make more sense to buy a fixed-APY bond or CD. This way, you can lock in a higher yield if and when market interest rates begin to drop.

What Factors Affect APY?

Several factors can affect the annual percentage yield on your investments and savings accounts. The most significant factors are interest rates, compounding frequency and the length of the investment. 

In general, the higher the interest rate on your account, the more likely it is your account will yield a higher APY. However, interest rates are not static, and they fluctuate over time. A change in interest rate could mean a significant difference in your APY, which is why the interest rate on your account is something you should always monitor closely, especially if you are investing for the long term.

Compounding frequency can also affect the APY on your account. Simply put, the more often interest is compounded, the more interest you will earn over time. Generally speaking, long-term investments, such as retirement savings accounts, will have lower interest rates than short-term accounts like standard savings accounts.

Examples of APY in Action

Imagine that you have a high-yield savings account that pays a 5% APY. If you have $10,000 invested, you’ll earn $500 in the first year. However, if you keep that money in the account and let compound interest do its work, you’ll have $11,025 after two years, $11,576.25 after three years, $12,155.06 after four years and $12,762.82 after five years. If you had instead earned simple interest, which doesn’t compound, you’d only earn $500 per year, for a total five-year balance of $12,500.

While this may not seem like a huge difference, the longer you let your interest compound, the more your APY will work to your advantage. If you can earn 10% annually on that $10,000 over 40 years, for example, the additional earnings you receive from compounding will be very noticeable — specifically, you’d have $537,006 vs. just $50,000.

Takeaway

APY is an important term to understand if you want to maximize your money’s growth. APY measures the interest earned on an investment or savings account over one year and considers the effect of compounding interest. Knowing how to calculate APY and how it affects your investments can help you make informed decisions about where to put your money. When comparing different types of financial products, always compare their APYs to make an informed decision.

Valerie Smith and John Csiszar contributed to the reporting for this article.

Data is accurate as of July 11,2024 and is subject to change.

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