What Exactly Is APY?
In the hustle and bustle of everyday life, and without the benefit of training in money management, banking terms can be confusing, especially expressed as acronyms. Over 60% of American consumers use credit cards, averaging about four credit cards per person. This means Americans in total use over 500 million credit cards.
Is APR The Same As APY?
So it’s not surprising that many Americans have a bit of working knowledge about APR—Annual Percentage Rate—the amount banks charge for using a credit card. Consumers comparison shop for credit cards by using APR to determine which cards to apply for, seeking lower APR charges over higher ones.
APR is expressed by a percentage, and it is charged against a carried balance as interest. The amount owed is calculated by multiplying the balance times the APR and adding those two numbers together. So on a balance of $1,000 with a 23.4% APR, the amount owed would be $1,000 times 23.4% ($234), added together to equal $1,234. (TIP: A math shortcut is to multiply the balance times the whole number 1 along with the decimal reflecting the percentage. So in this example, multiplying the balance times 1.234 will quickly give the correct answer.)
Understanding APR makes it easier to comprehend APY.
So Then What’s APY?
APY is the acronym for Annual Percentage Yield. APY is an amount of interest received instead of interest paid out.
Like APR, it is expressed as a percentage, and it is similarly calculated. Unlike APR, consumers would look for higher APY rates rather than lower rates, in order to receive more benefits paid out.
How does APY work?
Say an account offered a 0.6% APY. With $1,000 in the bank, expected earnings would be the $1,000 times the 0.6% APY, or $6, at the end of a year, right?
But interest is paid—or in this cased paid out, yielded—wouldn’t be paid out annually, but instead monthly. It is also compounded, so the calculations are slightly more complicated.
To calculate the monthly yield, you’d have to take the annual yield and divide it by 12, the number of months in a year. The 0.6% APY would be divided by 12 to equal 0.05%, meaning this imaginary account would yield 0.05% extra on each month’s balance (multiply $1,000 times 1.0005).
But that’s not all. The yield is compounded, so there’s an additional step to be considered. If the same $1,000 were left in the account all year, the total yield would be $1,006.02.
Explain That One More Time
The higher-than-expected yield—the extra 2 cents in the example—is the result of compounded interest. Each month that interest accrues is not calculated on the original balance, but rather on the current monthly balance.
To continue the example, the interest would not pay each month on the original $1,000. Instead, the yield would be calculated against the increasing current monthly balance.
The first month’s yield would be the original $1,000 times the monthly 0.05%, or 50 cents. The new balance at the end of that month would be $1,000.50. Consequently, the next month would not use the original $1,000 amount, but rather this new $1,000.50 balance to calculate the yield.
While the extra 2 cents earned in the example isn’t much of a difference, larger amounts would mean a more significant change. Adding more money each month to the savings would mean a higher monthly yield would compound.
Suppose the account holder added $100 more to the account each month. The annual balance would have increased by $1,200, the 12 monthly payments of $100 each. But it would have also increased the monthly amount on which the compounded interest is calculated. The ending balance for the year, if no money were withdrawn, would equal $2,209.62.
Instead of looking for the lowest APR for a credit card, shopping for a savings account should consider the highest yielding APY. The other concern is making sure the service charges are low. Some banks will waive monthly service charges if the account holder maintains a minimum balance.
The higher the yield percentage, the more interest your money will earn with zero effort on your part. And high yield accounts are safe, as the FDIC backs them. They are federally insured even if the bank fails.