Annual percentage yield (APY)

by · July 14, 2012

Whether you are borrowing money to make a large purchase or depositing your money in a financial institution so you can make money (e.g., savings account, certificate of deposit), you will need a basic understanding of some key financial terms: annual percentage rate, annual percentage yield, and finance charges.

Annual Percentage Yield (APY)

This is the annual rate of interest plus the effect of compounding on the interest earned. This is the number quoted when banks and other financial institutions try to get you to deposit money in savings accounts or buy certificates of deposit.

In these cases, you are the lender, so the higher the APY, the more money you will make from amounts on deposit.

Example

  • 8-month CD
  • Interest rate = 4.65%
  • APY = 4.75%

Definitions

  • The principal in financial formulas is the balance upon which interest is paid.
  • Simple interest is interest paid only on the original principal, and not on any interest added at later dates.
  • Compound interest is interest paid on both the original principal and on all interest that has been added to the original principal.

Compound Interest Formula for Interest Paid Once a Year

A = P X (1+APR)Y

A   =   accumulated balance after Y years

P   =   starting principal

APR   =   annual percentage rate (as a decimal)

Y   =   number of years

The annual percentage yield (APY) is the actual percentage by which a balance increases in one year. It is sometimes also called the effective yield or simply the yield.

APY = relative  increase = absolute increase / Starting principal