Annual Percentage Yield (APY) Explained

Jun 24, 2018 10:30:00 AM

When looking at financial products and services, there are many essential terms to understand. One of the most important acronyms to know is APY, or annual percentage yield. Though it may sound complicated, APY is actually quite simple: it describes the total annual rate of return with compound interest. To understand APY, it’s a good idea to start by understanding how interest rates and compound interest work.

Interest rates

When you deposit your money into a bank or credit union, that financial institution doesn’t just let money sit there and do nothing. The bank will actually invest your money and engage in other financial transactions. In exchange for allowing the bank to use your money, your money will be subject to an interest rate. In essence, you are loaning your money to the bank, and the interest rate is how much you will receive in return.

Simple interest is the amount that your money will appreciate in one year, without taking into effect compounding. Let’s say you have a savings account with $10,000 in it and an interest rate of 1.5 percent. Simple interest is merely the principal multiplied by the interest rate. So your account would be worth $10,150.00. after one year. However, many financial institutions offer monthly compounding interest, which gives you a better return on your money.

Compound interest and APY

Whereas simple interest only calculates the interest rate once for an entire year, compound interest applies 1/12th of the interest rate every month. The result is that your money will grow more because you earn interest not only on your principal, but also on any interest previously earned. In the example provided above, your account of $10,000 would only earn $150 with simple interest after one year, but with monthly compound interest you would earn $151.04. This may not seem like a big difference, but as the principal and time increase, this can result in drastic differences.

APY is thus the total amount that your account will grow within a year, expressed as a percentage. The APY can be larger than the annual interest rate because of compounding. Banks and financial institutions use APY to measure the actual interest increase of an account if left untouched for one year.

Why is APY important?

APY lets you understand at a glance exactly how much your money will grow with a particular financial product or account. Choosing a savings account with a high APY will ensure that you profit the most from your savings. When compound interest is calculated over long spans of time, even small differences in APY can have big consequences. Let’s say that one bank can offer you an APY of 1.5% and another offers you 1.3%. It doesn’t seem like much difference, but consider the effect of the rates over a span of 10 years. If you started with $10,000, the difference would be a gain of $1617.25 in the first account vs $1387.48 in the second.

When opening a new account or choosing a financial product, understanding the APY of your product is essential for ensuring you make the right choice and get the most out of your money.

How is annual percentage yield determined?

APY will vary from one institution to the next and from one financial product to the next. Institutions determine how much APY to provide based on many factors, including risk, the financial standing of the institution, market competition, overall market conditions and federal interest rates.

What is a ‘good’ APY?

In general, the higher the APY the better. However, you need to consider if the financial product is right for you. Some financial products offer high APY, but require larger deposits or fixed terms, which might not suit your needs. Once you know which product is right for you, do your research to ensure that you are getting the best APY rate possible. Many savings accounts offer very low APYs, so it’s important to do your research.

Harvard University Employees Credit Union offers a variety of savings and checking accounts to meet your needs with competitive APY rates, so be in touch if you have any questions about what’s right for your unique financial situation.

Tags: Savings, Money Tips, Banking Tips