10/7/2022
When comparing bank products or reviewing terms and conditions for an account, personal loan, online credit, certificate of deposit or investment, you need to be alert. Understanding details such as the nominal interest rate, APR and APY can make a big difference in terms of earnings and savings.
We've already covered Annual Percentage Rate (APR), now we'll tackle Annual Percentage Yield (APY).
What do you need to understand about APY?
Essentially, the Annual Percentage Yield is a value that tells you how much profit or debt is generated by compounding interest over the course of a year.
When it is an investment or savings account, we look for a high APY. If it is a credit or loan, a low APY is preferable.
At this point we must separate this concept from the nominal interest rate (NIR) to better understand it. Unlike the annual percentage yield, the NIR represents a value that applies for one year, but does not consider compound interest.
Let's use an example to explain it better:
Assuming you have a savings account with $5,000 USD and the bank gives you an interest rate of 2.5%. If you keep this same amount for the whole year and the interest is deposited at the end of that period, you would earn $125, being the APY also 2.5%. On the other hand, if interest is deposited several times during that period, the APY would go up, being above the NIR.
While it is true that with small amounts the difference is not so noticeable, a larger amount could provide a good amount over time.
This is important to know how applying for a savings account or certificate of deposit with an APY calculated daily or monthly affects you. The more frequently compounding is applied, the higher the final APY will be.
How to calculate APY?
You don't have to be a mathematician to understand the formula for calculating APY. You can even do this using a spreadsheet if you don't want to do it manually. The equation is as follows:
APY = (1 + r/n)n - 1
In this case, the value of r is represented by the annual interest rate and n is the number of compound interest periods applied during the year.
Let's take another simple example. If your bank gives you 5% interest, the resulting APY for this percentage is 5.116%. Each time interest is compounded monthly on the current balance, you get an increase and so on until the end of the year.
You can test daily with 360 or 365 days or even quarterly so you can get a better feel for how it works.
Rates of return vs APY
Assuming you have several investments, rates of return tell you how much you are going to get at the end of the term of those instruments.
These percentages can be difficult to calculate when you have several investment products and a different compounding is applied to each one. For example, one may be monthly and another biannual.
If you want to calculate the gain by simply applying the nominal interest rate during the year in question, it will give you a less accurate result than the APY. This is because you are not including the effects of compound interest.
The shorter the compounding period, the faster the investment will grow.
When is it better to use APY or APR?
It should be clarified that it is from the NIR that the value related to the annual percentage yield is derived. In a similar way, the APR works like the APY, but does not include compound interest in its calculation.
The function of the annual percentage rate is to tell you the sum of the nominal interest rate and the expenses or fees of a product.
For example, if you have a credit card, the APY with this type of financing will always be higher than the APR. The reason is that they add monthly interest to your balance, so you have to pay interest on interest.
It is the same situation when you compare it to a savings account or a product that generates some kind of dividend.
On the other hand, calculating the APR for a fixed-rate mortgage loan is much more accurate than using the annual percentage yield. This is because the bank or lender does not usually add interest to your balance and that value is interpreted as the final cost of the transaction, which is very useful.
Concepts such as APY, APR and NIR are important to take care of your finances. If you plan to use Busconomico's comparator, evaluate these data to choose wisely.
Español: Qué es el APY y cómo se calcula