When you invest in a product, you expect a return in excess of what you paid for that product. It’s APY. What is APY? It represents the annual percentage return and represents the rate of return on an investment. The APY takes into account compound interest payments over the course of a year. It is generally used to show the prospect of short term investments which consist monthly (or more frequently). The shorter the time between dialing, the higher the APY.
APY refers exclusively to the return on investments; however, it is the same concept as the annual effective rate (TEAR), which is the actual interest paid to a creditor by a borrower. APY is an important concept for understanding the viability and profit potential of a short-term investment. Here’s what you need to know.
How does APY work?
APY integrates everything into a fixed investment to show you the real rate of return. This means that APY keeps track of fees and other expenses and assumes that you are not adding or removing funds between compounding periods. The higher the APY, the better.
Different types of financial products can carry fixed or variable APYs. Something like a savings account will offer a variable APY, which can increase or decrease depending on the fluctuating interest rate offered by the bank. Something like a bond or certificate of deposit will have a fixed APY. This means that the APR will remain consistent for the duration of the investment, thus resulting in a fixed APY.
Whether fixed or variable, regardless of the product, APY works by measuring the composite value of the main balance. For example, if you deposit $ 100 into an account that offers an APR of 12%, you earn 1% per month in interest. If this interest accumulates, the principal balance grows by just over 1% each month, resulting in APY.
How to calculate the annual percentage return
As mentioned above, the APY formula is generally the same as the Annual Effective Rate (EAR) formula. To calculate APY, follow this equation:
APY = (1 + r / n) n-1
- r = the period rate
- n = the number of compounding periods
From the equation, it is easy to see that the more compound periods, the higher the return. For example, consider a fixed investment of $ 1,000 at 5%, compounded quarterly. At the end of the year, after four compounding periods, you would have $ 1,050.95 at 5.095% APY. Now take this same amount and compose it quarterly over five years: it becomes $ 1,282.04.
The difference between APR, APY and nominal interest rate
There is often a lot of confusion around the difference between APR, APY and nominal interest rate. While these three concepts often work in tandem, they are quite different in terms of the information they provide to investors. Here’s what each means:
- Nominal interest rate. This is the annual interest generated by the principal balance. It does not take into account any additional costs or charges.
- Annual percentage rate (APR). This is the annual interest generated by the balance of the capital, including costs and fees, expressed as a percentage.
- Annual percentage return (APY). This rate takes into account the makeup to give investors a snapshot of the rate of return on an investment over a year.
Typically, banks and other financial institutions advertise their products through their APR or APY, whichever provides the most lucrative return prospect for investors. To help distinguish them, the 1991 Truth in Savings Act requires institutions to disclose both numbers, so that investors can compare them equally between products.
It is also important not to compare APR to APY when evaluating products. Comparing the APR to the APR also doesn’t work, as it ignores the effects of compounding and doesn’t predict the total return on investment. Instead, compare APY to APY across similar products, to get a clearer sense of return prospects.
APR vs APY: a question of perspective
Most often, APR appears in the context of debt accounts: credit cards, mortgages, loans, etc. with the language surrounding interest rates. If you are the borrower (debt account), the APR represents the interest rate you will pay, which tends to be the most important factor to consider. For lenders, APY is the most important variable: you want to know what your return will be.
APR and APY apply to both sides of the coin; it’s just a matter of perspective where the interest metric is more important.
How can investors use APY to their advantage?
APY is a great tool for evaluating short term investment products. It is more revealing than the RPA in many cases because it represents the composition. For example:
Marvin is trying to decide between a zero coupon bond that pays 6% at maturity and a CD that pays 0.5% per month, with compounding. The APR of the two products appears the same (6%). However, CD’s cap rate makes it a more lucrative investment as the APY is actually 6.17%.
APY allows investors to make a more informed decision on where to invest in short-term vehicles. Inclusion of composition in the equation provides more information than the RPA is capable of providing at a surface level.
The bottom line on annual percentage return
What is APY? If you are a short term investor, APY is a valuable tool to help you understand the expected return on investment and to compare similar products. It is also an important measure alongside the APR in evaluating different products for borrowers and investors. Ultimately, it’s a way to gauge the power of a compound investment. In a nutshell, APY is exactly what you should be looking at if you are trying to maximize short term returns.
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