What Is Your Annual Percentage Yield?

Annual percentage yield (APY) is the total interest charged on an account taking into account the affect of compounding rates. Compounding is a word used to describe the way interest can be charged on interest. For example, when you do not pay your credit card bill, the interest that you are charged rolls over into the next payment, and interest is again charged on this amount. Using this example, you can see why it is important to calculate APY and not just the interest rate on all of your financial accounts.

Calculating APY

To calculate APY, you will need to do a little bit of math. It is more complicated than a straight interest calculation, but this simple formula can be used across the board to calculate APY:

(1+periodic rate or interest rate)^total number of periods - 1

For example, if your credit card rate is 15 percent but it compounds monthly, your annual percentage rate is:

(1+.15)^12-1

As you can see, your APY is much higher than the APR the credit card company lists. 

 

APY vs. APR

In the example above, the importance of factoring in APY when you make financial decisions is demonstrated clearly. APY is always higher than APR on any account that compounds. However, not all financial institutions list items in terms of APY and APR. In fact, most will choose one or the other. For this reason, it is critical to run the calculation yourself so you can understand the true interest you will be charged on an annual basis.

Borrowing with APY

As a borrower, you will likely receive a quote for APR from your lender. The lender knows the APR sounds a lot lower than the APY. So, the lender will quote you the lowest interest possible, giving it to you in terms of simple periodic rate. Ask the lender how often the interest compounds. This is a more accurate portrayal of interest rate. APY is charged on most revolving loans and installment loans including auto loans, mortgages and credit cards. With installment loans, you do not have the option of paying off interest to reduce the compounding effect. With a credit card, you can pay off your interest each month, which will eliminate the affect of compounding interest. However, if this is your plan, you must be disciplined to pay off your bill each month or you will quickly throw away money to interest fees.

Investing with APY

When you approach a bank to invest in a savings account or CD, you will likely be quoted APY instead of APR. In this case, the financial institution wants to quote you the highest possible interest. This is not untruthful or illegal, but you still want to look out for the difference. When comparing possible investments, make sure they are all listed in terms of one rate or the other. If you receive one quote in APR and one in APY, you will not be able to properly consider which is more favorable for your unique situation.


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