What Is Annual Percentage Yield (APY) & How Can You Calculate It?

Earning interest is the primary reason why people choose to deposit their money with banks and bonds. Interest-bearing accounts offer two models: simple interest and compound interest. Of the two, compound interest results in higher potential returns, exceeding the nominal interest rate. This is because interest is calculated not on the principal deposit but on the deposit plus the interest it accrues for every compounding interval.

The actual rate of return on an investment with compound interest is known as annual percentage yield (APY). Below, we'll cover how to calculate APY for a more accurate estimation of your potential returns.

What Is Annual Percentage Yield (APY)?

In the simplest terms, APY is the rate of returns on an investment after one full year of compound interest. Since compound interest is continually added to the principal amount, each subsequent interest payment increases to reflect the larger principal. The more compounding periods in a year, the higher the APY will be.

Components of APY

APY consists of two main components:

1. Nominal interest rate: This is the annual interest rate you earn on your investment. A higher nominal interest rate increases APY.
2. Compounding frequency: How often interest is added to your investment, which can theoretically be any number, but is typically annual, semi-annual, quarterly, monthly, or daily. More frequent compounding boosts APY. For example, monthly compounding typically results in a higher APY than annual compounding at the same nominal interest rate.

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How to Calculate Annual Percentage Yield

To check the APY of a given investment, you can use the following formula:

This formula allows you to determine the effective annual rate of return on investment, taking into account both the nominal interest rate and the compounding frequency.