.png){kind=logo}
APY
APY, or Annual Percentage Yield, is a financial metric used to calculate the real rate of return earned on an investment, accounting for the effect of compounding interest over a one-year period. Unlike simple interest that only earns on the principal, compounding interest earns on both the initial principal and the accumulated interest from previous periods.
How APY Works:
- Compounding Interest: APY reflects the total amount of interest that will be earned on an investment by the end of one year, considering that interest is compounded, or added to the initial sum, at regular intervals throughout the year. Each time interest is added to the account balance, it becomes part of the principal for the next interest calculation.
- Calculation: The formula to calculate APY is APY = (1 + r/n)^n - 1, where r is the annual interest rate and n is the number of compounding periods per year. This formula helps determine how much more you can earn due to the compounding effect.
Importance of APY:
- True Earnings: APY provides a more accurate depiction of potential earnings compared to the nominal interest rate because it includes the effects of compounding. This is particularly useful for comparing different investment products where the compounding intervals may vary (e.g., monthly vs. quarterly).
- Decision Making: For savers and investors, APY is a crucial metric as it allows them to compare the efficiency and profitability of different financial products like savings accounts, certificates of deposit, bonds, and more.
APY vs. APR:
- Annual Percentage Rate (APR): Unlike APY, APR does not take into account the compounding of interest within the year—it only measures the simple interest rate annually. For borrowing, APR is a useful figure as it reflects the base rate of borrowing without compounding.
- Comparison: APY will always be higher than or equal to APR when there is compounding involved, making it a more accurate measure of investment growth or the effective cost of a loan over time.
In summary, APY is a critical financial measure for evaluating the true return on an investment or the real cost of a loan, providing a comprehensive view by including the effects of compounding interest.