APY, or annual percentage yield, is a measure of how much you will earn (if you are investing) or how much you will have to pay (if you are taking out a loan). It accounts for compounding interest.
If you hear APY being used for home loan options, pay attention. With a higher APY on a loan, you’ll be paying more over time.
APY Vs. APR: What’s The Difference?
It’s easy to confuse APY and APR (annual percentage rate). They’re both ways to determine interest, calculating how much you earn or pay yearly. Advertisers may use one or the other to cause confusion and make a loan or investment seem better than it is. It’s important to be able to distinguish between the two.
One difference you’ll see is what markets they’re used in. Generally, you’ll see APY tied to investments, where you earn interest, and APR used by lenders, where you pay interest.
A reason for this is that APY accounts for compounding interest, while APR does not. APR is a lot simpler to calculate. All you need to do is multiply the amount of money paid by the annual percentage and you’ll have If the interest compounds often, the difference between APY and APR will be large.
Variable And Nonvariable APYs
Depending on the terms and conditions, APYs may be variable or nonvariable. Sometimes these variable rates are referred to as “adjusted” or “floating.” With a variable APY, the yield may fluctuate depending on the national interest rate average. In a good economy, investments with variable APYs tend to yield better results.
To contrast this, nonvariable APYs have the same rate, month-after-month, year-after-year. An investment with a non-variable APY yields the same, no matter the economic situation.
Why Compounding Matters To APY
As we mentioned when talking about APR vs. APY, the major difference is that APY accounts for compounding interest. Compounding matters because it means the interest grows over time.
Since APY is used in situations where you’re earning money, compounding interest means your investment is growing. Small increases over a year can add up to a large gain over the course of several years as the interest continues to build.
APY Calculation Examples
For these examples, we’ll use APY when talking about investments, as that’s how it’s generally used. However, if you’re trying to calculate how much you’ll owe, the math is the same. Just replace the principal with your debt.
To calculate APY, use this APY formula:
APY = (1 + r/n)n – 1
The r is the interest rate as the decimal. For example, 0.06% would be written as 0.0006. The n equals the number of times an investment compounds in a year. For this example, we’ll say the investment compounds monthly, so 12 times a year.
We’ll plug in our numbers here:
APY = (1 + 0.0006/12)12 – 1
In this example, APY = 0.060017%. To figure out how much this APY earns you over a year, you need to multiply it by the principal. For this example, we’ll say the principal you have in your account is $80,000. Follow this formula:
(APY x principal) + principal = total after a year
That puts the total after a year at $80,048.01. Your APY has generated $48.01. This isn’t a large increase. It’s comparable to what you would see if you left your money in a savings account for a year.
For a larger return, consider investing your money into a 12-month certificate of deposit (CD). As opposed to a savings account with 0.06% APY, CDs average 0.26% APY. The same $80,000 would produce $208.04 in compound interest in a year.
Keep in mind that’s just for one year. Every year adds a little more money, growing year after year. If growing your savings through interest is a goal, putting your money in an account with a higher APY would benefit you.
Being aware of what different financial terms mean is the start to financial success. Want to learn more about homeowning and managing your finances? Visit the Quicken Loans® Learning center.