Annual Percentage Yield - APY

The annual percentage yield (APY) is the effective annual rate of return taking into account the effect of compounding interest. APY is calculated by:

The resultant percentage assumes that the funds will remain in the investment vehicle for a full 365 days.

The APY is similar in nature to the annual percentage rate (APR), which is used for loans rather than investments' and states' total borrowing costs, including fees, as a single percentage number. Both are standardized measures of interest rates, though unlike APR, the equation for APY does not consider account fees, only compounding periods. Its usefulness lies in its ability to standardize varying interest-rate agreements into an annualized percentage number.

In an investment scenario, the rate of return is simply the amount by which an investment grows over a specified time period, expressed as a percentage of the original investment amount. Rates of return can be difficult to compare across different investment vehicles, especially when such vehicles feature different compounding periods. For example, one investment vehicle compounds interest monthly, another compounds quarterly, another biannually and, lastly, one compounds interest only once per year.

Comparing these rates of return by simply restating each percentage value over one year gives an inaccurate result, as it ignores the effects of compounding interest. The shorter the compounding period, the faster the investment grows, since at the end of each compounding period, interest earned over the period is added to the principal balance, and future interest is calculated on the larger principal.

APY standardizes each rate of return not only by restating it over one year but by adjusting the rate of return to assume a one-year compounding period.

For example, suppose you are considering whether to invest in a one-year zero-coupon bond that pays 6% upon maturity or a high-yield money market account that pays 0.5% per month with monthly compounding.

At first glance, the yields appear equal because 12 months multiplied by 0.5% equals 6%. However, when the effects of compounding are included by calculating the APY, the second investment actually yields 6.17%, as (1 + .005)^12 - 1 = 0.0617.

An investment offering an interest rate of 6% divided by 365, with interest compounded daily, carries an even higher APY. This is because the principal balance on which interest is calculated increases every day, rather than once per month or once per year.