Annual Percentage Yield (APY) is a measure used to calculate the real rate of return on an investment or savings account, taking into account the effect of compounding interest. It provides a more accurate reflection of the earning potential compared to the nominal interest rate because it includes the interest earned on both the principal amount and the accumulated interest over a year.
Formula for APY
The formula to calculate APY is:
APY=(1+rn)n−1APY = \left(1 + \frac{r}{n}\right)^n – 1APY=(1+nr)n−1
Where:
- rrr is the nominal interest rate.
- nnn is the number of compounding periods per year.
Key Points
- Compounding Frequency: APY increases with the frequency of compounding (daily, monthly, quarterly, etc.).
- Comparison Tool: It is useful for comparing the earnings potential of different accounts or investments with varying compounding periods and interest rates.
- Transparency: APY helps consumers understand the true return on their deposits or investments.
Example Calculation
If you have an account with a nominal interest rate of 5% that compounds monthly, the APY can be calculated as follows:
APY=(1+0.0512)12−1≈0.05116 or 5.116%APY = \left(1 + \frac{0.05}{12}\right)^{12} – 1 \approx 0.05116 \text{ or } 5.116\%APY=(1+120.05)12−1≈0.05116 or 5.116%
This shows that the effective annual return, when interest is compounded monthly, is slightly higher than the nominal rate of 5%.
