Are you tired of low-interest rates on your savings account? Want to make your money work harder for you? Then, you need to know about APY. This three-letter acronym is your ticket to earning more on your savings. But what exactly is APY? Let’s dive in.
What is annual percentage yield (APY)?
Annual percentage yield, or APY, is a way to measure how much money you can earn from a bank account over a year. It includes both the interest you earn and how often that interest gets added to your initial money.
APY is crucial when you’re deciding where to put your money. It helps you compare different options like high-yield savings accounts, money market accounts, and certificates of deposit (CDs) fairly. The higher the APY, the more money you can make in a year.
Example of how compound interest works
Imagine you put $10,000 in an account that earns 5% APY, compounded annually. In the first year, you’d earn $500 (5% of $10,000). Now, your total is $10,500. In the second year, you earn 5% of $10,500, which is $525. So now you have $11,025.
This cycle continues, and the power of compound interest starts to show over time. After 10 years, your initial $10,000 deposit would have grown to $16,289. That’s an increase of over $6,000 without doing anything other than leaving your money in the account!
How to calculate APY
The easiest way to calculate APY is with an online compound interest calculator. But if you want to do it by hand, you’ll need to know the account’s interest rate and the compounding frequency. Here’s the APY formula:
APY = (1 + (interest rate / compounding frequency)) ^ compounding frequency – 1
Let’s break this down into steps:
Step 1: Divide the interest rate by 100 so it’s a decimal. For example, if the interest rate is 2%, you would divide 2 by 100 to get 0.02.
Step 2: Determine the compounding frequency. This is how often the interest is calculated and added to your account balance. It could be daily, monthly, quarterly, or annually.
Step 3: Plug in the values into the APY formula. For example, let’s say you have a high-yield savings account with an interest rate of 2% that compounds monthly. Here’s what the calculation would look like:
APY = (1 + (0.02 / 12)) ^ 12 – 1 APY = (1.001667) ^ 12 – 1 APY = 0.0202 or 2.02%
So, in this example, the APY of the savings account is 2.02%. This means that if you deposited $1,000 into the account and left it there for a year, you would earn $20.20 in interest.
Compounding frequency can have a significant impact on your APY. The more frequently interest compounds, the higher your APY will be. So, when comparing savings accounts, make sure to consider both the interest rate and the compounding frequency to find the highest-paying one.
APY vs. APR: What’s the Difference?
APR stands for annual percentage rate, which is the interest rate you’ll pay on a loan or credit card. APY stands for annual percentage yield, which is the total amount of interest you’ll earn on a savings account over the course of a year.
The key difference is that APR reflects the cost of borrowing money, while APY reflects the earnings potential of saving money. When it comes to APR, smaller is better because it means you’ll pay less money over time and become debt-free faster. Regarding APY, bigger is always better because it means you’ll earn more money over time.
How interest rates affect APY
Interest rates play a critical role in determining the APY of a savings account. When interest rates go up, the APY on your savings or investments can increase, which means your money grows faster. On the flip side, when interest rates drop, your APY might decrease, so your money grows more slowly. These changes can have a significant impact on your long-term savings goals.
Some savings products, like CDs, have fixed interest rates. So whatever APY is advertised when you open the account is the same rate you’ll earn until it matures.
Other accounts, like savings and money market accounts, have variable APYs that can change at any time. The primary factor that drives these changes is the federal funds rate set by the Federal Reserve.
These changes in interest rates can greatly impact your long-term saving goals.
For instance, if you have $10,000 in a savings account with a 3% APY, after 10 years you’d have around $13,439. But if the APY goes up to 5%, you’d end up with about $16,289–that’s $2,850 more in your pocket, just because of the higher APY.
Understanding annual percentage yield
Understanding APY is a cornerstone of financial literacy. It’s crucial for anyone looking to save money and grow their wealth over time.
By choosing a savings account with a high APY and frequent compounding, you can maximize your earnings and achieve your financial goals more quickly. In addition to getting the best APY, doing a financial audit can help you uncover even more ways to build a strong financial foundation.
FAQs
What is a good APY rate?
A good APY rate is one that’s higher than average for the type of account you’re considering. For example, if the average savings account interest rate is 0.50%, a good APY for a savings account would be anything above this. The Federal Deposit Insurance Corporation (FDIC) publishes average rates for checking, savings, money market, and CD accounts.
What is the difference between APY and APR?
APY (annual percentage yield) is the total amount of interest you’ll earn on a savings account over a year. APR (annual percentage rate) is the interest rate you’ll pay on a loan or credit card, including fees. The key difference is that APY reflects the earnings potential of saving money, while APR reflects the cost of borrowing money.
How is APY calculated?
APY is calculated using the formula: APY = (1 + (Interest Rate / Number of Times Interest Added per Year)) ^Number of Times Interest Added per Year – 1. This formula considers both the interest rate and how often interest is compounded in a year to estimate how much your money can grow.
Written by Cassidy Horton | Edited by Rose Wheeler
Cassidy Horton is a finance writer who’s passionate about helping people find financial freedom. With an MBA and a bachelor’s in public relations, her work has been published over a thousand times online by finance brands like Forbes Advisor, The Balance, PayPal, and more. Cassidy is also the founder of Money Hungry Freelancers, a platform that helps freelancers ditch their financial stress.
Read more:
The post What Is Annual Percentage Yield (APY)? appeared first on Prosper.