When comparing accounts with compounding returns, such as high-yield cash accounts and CDs, consider stacking up the annual percentage yield, often referred to as APY.

APY is a percentage value that represents the total amount of interest you earn on certain types of accounts during the year. It uses compounding interest and bases its value on the stated interest rates and the number of compounding periods during the year, such as daily or monthly. This earned interest goes toward your account balance and helps your account grow faster.

Comparing APY rates instead of solely interest rates can help you better understand how much you can expect to earn on your investment over a 365-day period. This article takes a closer look at APY rates and how it can impact your personal finances.

How is APY calculated?

Before you can calculate APY, get familiar with several key factors:

• i: interest rate on account
• n: number of compounding periods in a year
• d: initial deposit

With this information, you can use the annual percentage yield formula below to determine the APY percentage.

[(1 + (i / n))n – 1] * 100 = APY

For example, let’s say you’re opening a high-yield savings account. The interest rate is 3%, and it compounds monthly. The APY rate is 3.04%.

((1 +(0.03 / 12)) ˆ12 – 1] * 100 = 3.04%

You can then use this figure to determine how much you can earn during the year. For instance, if you deposit $10,000 into this savings account, you can expect to earn $304 in interest in a year for a total balance of $10,304.

You can also save yourself this step by using an online annual percentage yield calculator. Financial calculators like this can help you make informed decisions.

APY vs other measures of interest rates

APY is not the only method for measuring interest. Other methods include nominal interest rates and annual percentage rates (APRs). The major difference between APY and these other methods for measuring interest is that APY uses compounding rates, and the other methods do not.

Below are more details about other ways to measure interest rates.  

Nominal interest rates

Nominal interest rates are one of the easiest methods to understand and calculate.

You can multiply your deposit by the listed interest rate to calculate the interest earned. Using the example above, you can calculate interest earned using the nominal interest method by multiplying the $10,000 initial deposit by 3%, for a total of $300 (10,000*0.03). The $4 difference between using the nominal interest rate over APY may not seem like a lot, but over time, it can make a significant difference in how fast you can grow your wealth.  

APR vs APY

As mentioned above, the major difference between APR and APY is that APR doesn’t use compounding interest. This is because APR is typically associated with loans and credit cards. Lenders often use APR to determine the amount of interest you owe during the course of the year, rather than how much interest you earn.

The benefits of high APY rates

Typically, higher APY rates result in higher returns. This factor is especially true for long-term investments because over time, your account will continue to grow according to the set APY at the time.

Type of financial products with APY rates

There are several types of financial products that offer APY rates:

High-yield cash accounts

High-yield cash accounts often offer APY rates. These liquid accounts provide quick access to your money. Sometimes, they don’t require a minimum balance, and you’re able to deposit and withdrawal from your account within the parameters set by your bank.

Certificates of deposit (CDs)

CDs are another cash-saving option that often uses APY rates. Typically, interest on CDs accrues at the end of the period, and you can roll the full closing balance into a new CD. For example, if you earn $30 on a $1,000, 12-month CD, you can roll the entire $1,030 over into a new CD. You may face penalties if you need to withdraw your money before the stated end of the CD period. Therefore, the APY rates are often higher than those of high-yield  cash accounts to account for this risk.

Bonds

Bonds, whether issued by the federal government or private corporations, often offer APY rates. Much like with CDs, the issuer agrees to repay the bond plus earned interest at the end of a set period. Bond prices generally fall when interest rates rise (and vice versa) and are subject to risks, including changes in credit quality, market valuations, inflation, liquidity, and default so the APY rates are also often higher to account for these risks.

How to choose a yielding financial product

The Truth in Savings Act¹ requires banks, credit unions and other financial institutions to provide detailed information pertaining to accounts and investment options prior to consumers opening an account. This makes comparing options more transparent and easier to understand.

When stacking up your options, your first choice may be to invest in accounts that offer the highest APY with the hopes of achieving the highest return. However, considering a short list of factors can help lead you to  the correct option for your situation:

• Financial goals: Before choosing a yielding account, it’s important to set clear goals and objectives. For example, are you saving for retirement or planning to purchase a home? Retirement planning requires more long-term planning, while purchasing a home may require short-term gains.
• Risk tolerance: Generally, the higher the APY rate, the higher the risks associated with the investment. It’s important to understand the risks involved. For instance, if you want an account that gives you immediate access to your money, a high-yield cash account may be the right solution. On the other hand, if you’re OK setting aside a specific amount of money for a set period, then a CD investment may be a good option for you.
• Additional fees: Don’t forget to read the fine print. Many investment options come with annual fees or administration costs. Be sure to take these additional fees into consideration when comparing options.
• Initial investment: It’s also important to know right from the start how much money you want to invest. Some accounts have minimum investment requirements. Knowing which financial products you can qualify for allows you to narrow down your options.  

Our take

Earning a return on your cash accounts can be helpful to meeting your short-term and mid-term goals. Understanding APY rates can help you compare the rate of return. Be sure to also consider your personal goals and specific situation.