Annual Percentage Yield - Explained
What is APY?
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Table of ContentsWhat is Annual Percentage Yield?How Does Annual Percentage Yield Work?Differences between APY and Rate of ReturnHow Annual Percentage Yield is CalculatedAcademics Research on Annual Percentage Yield APY
What is Annual Percentage Yield?
This refers to the effective annual interest rate using compound interest. Any is mathematically denoted as:
APY = (1+r/n) * n-1
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How Does Annual Percentage Yield Work?
Similar to the annual percentage rate (APR), the APY is used for calculating the interest rates for loans, credit cards, and investments. However, the APY, unlike the APR, focuses on compounding interests rather than account fees. This method is crucial to measuring varying interest rate and turning them into percentages for loan and investment agreements.
Differences between APY and Rate of Return
Rate of Return is the amount of an investments growth over a given period of time. It is mostly denoted as a percentage of the initial capital. Rate of return has different difficulties calculating the interest rate of various investments, especially due to compounding. This is where the APY comes in, as it can easily calculate compounding interest without errors.
How Annual Percentage Yield is Calculated
Let us assume that you wish to invest in a 2-year zero-coupon note with returns of 9.6% when it gets to maturity. You also have another option of investing in a high-risk money market that gives 0.8% with compounding interest on a monthly basis. Merely looking at both investments, there are equal, since 0.8% monthly for one year is equal to 9.6%. However, when compounding interest is used, we can see that the second investment would yield a higher interest using the APY formula. An investment offering an interest rate of 9.6% per year, with daily compounding interest would be bigger than one that offers such yield once a month or once a year. This is because a new percentage is added to the 9.6% each day, unlike that of monthly (which gets an increase once in a month), and yearly (which gets an increase per annum).