Financial Glossary
Annual Percentage Yield (APY)
Annual percentage yield (APY) is the effective annual rate of return on a deposit or investment account that accounts for the effect of compounding interest within the year. APY = (1 + Periodic Rate) to the power of n minus 1, where n is the number of compounding periods per year. APY is always equal to or greater than the stated annual percentage rate (APR) because compounding means interest earned in earlier periods earns additional interest in later periods. The more frequent the compounding -- daily versus monthly versus quarterly -- the higher the APY relative to the same APR. APY is the disclosure standard for deposit products in the United States under Truth in Savings regulations.
Problem & Application
A business savings account offers a 5% APR compounded monthly. Monthly rate = 5% divided by 12 = 0.4167%. APY = (1 + 0.004167) to the power of 12 minus 1 = approximately 5.12%. A competing account offers 4.95% APR compounded daily. APY = (1 + 0.04950/365) to the power of 365 minus 1 = approximately 5.07%. Despite the lower APR, daily compounding narrows the gap but does not close it. For a campground operator holding $500,000 in a reserve account between peak seasons, the difference between 5.07% and 5.12% APY is approximately $250 per year -- small individually, but the habit of comparing APY rather than APR ensures the business captures the highest effective yield available on idle operating cash.
In Short
APY is an essential metric for comparing financial products and understanding the compounding impact on returns, enabling better decision-making for investors and savers.