What Is Annual Percentage Yield?
In finance, the Annual Percentage Yield (APY), also known as the Effective Annual Rate (EAR), is the percentage of increase or “rate of return” earned over investment for a year. The APY is a recognized indication of a financial product’s underlying interest rates.
APY has several advantages, and one of the most important ones is that it considers the compounding impact. Remember that compounding is the process through which an asset or debt earns interest on both the principal and the accumulated capital gains or interest. In other words, the annual percentage yield (APY) represents the actual interest rate that a creditor or an investor would incur.
It’s crucial to understand how frequently an investment compounds because the more regularly investment compounds, the quicker the investment increases. The interest generated throughout the period is added to the principal balance each moment it compounds. Future interest payments are computed on the more significant principal rate.
You can best explain when your money increases through time by evaluating your APY. Even if the increase is slow at first, compounding interest can help it expand over time. APY can help you obtain the best from your investment, savings, or any of your interest-bearing accounts.
The following mathematical equation is used in computing the APY in general:
APY = [(1 + (i/N) )^N] – 1
Where i is the nominal interest rate, and N is the number of compounding interest.
Annual Percentage Yield Example
Let’s say Nelson put $100 in the bank for a year at 5% interest, and it was compounded quarterly. Just at the end of the year, he will receive $105.09, which is the same as $105 if you paid simple interest. The annual percentage yield (APY) would be [(1 +.05/4) * 4] – 1 =.05095 = 5.095 percent.
It pays a yearly interest rate of 5% compounded quarterly, for a total of 5.095 percent. However, if the man had put that $100 in a quarterly compounding account for four years, his initial investment would have risen to $121.99, and it would have cost $120 if it hadn’t been compounded.« Back to Glossary Index