The annual percentage yield (APY) is a normalized interest rate based on the compounding period of one year. The APY provides a standardized representation of the underlying interest rates of financial products.
The primary advantage of the annual percentage yield is the consideration of the compounding effect. Recall that compounding is essentially a process in which an asset or liability earns interest on both principal and capital gains or accrued interest. In other words, the APY reflects the true interest rate that a lender or an investor will earn.
Using the annual percentage yield, one can compare various financial products whose interest rates come with different compounding periods. However, the APY does not consider potential account fees that can affect the net gain.
The general formula to calculate the annual percentage yield (APY) is expressed using the following mathematical equation:
i – the nominal interest rate
N – the number of compounding periods
For example, if the interest is compounded monthly, then the relevant formula to calculate the APY is the following:
APY vs. APR
Although both the annual percentage yield (APY) and annual percentage rate (APR) are representations of an interest rate, there is a significant distinction between the two terms. Unlike the APY, the APR does not consider compounding effects.
As mentioned above, the primary advantage of the APY over the APR is the standardized representation of interest rates. In other words, the former can be utilized to compare products with various compounding structures for interest rates.
Since the APY takes into consideration the compounding effect, it will be higher than the APR. Due to this reason, financial institutions tend to prefer to quote the APR in their loan offerings, as the lower rate makes their deals appear more attractive to potential customers.
For the same reason, the annual percentage yield is frequently reported in the offerings of investment products or interest-earning bank accounts, as the APY figure will appear more attractive to investors.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: