Annual percentage yield or APY is a common term often found in all kinds of bank offers like loans and credit cards. APY is the same concept as effective annual rate or EAR. Former is used more in investing while later is used more for loans.
Having a good understanding of both APR (annual percentage rate) and EAR may be crucial in your decision-making process. We’ve covered APR in the separate text, and here we’re going to focus on EAR in addition to annual percentage rate. Let’s see what they stand for.
What Is APY and EAR?
Annual Percentage Yield is the annualized interest rate. This term is used in the banking industry to describe the interest rate on a savings account. It is also known as the nominal rate of interest. The APY is expressed as a percentage and it represents how much you will earn on your investment over a year.
So, it is basically computed by taking the interest rate and multiplying it by the number of periods in a year. APY can be calculated by taking the nominal interest rate and multiplying it by the number of periods in a year.
APY is often used to compare different investments because it takes into account both the size of your deposit and its return. EAR takes into account all costs associated with borrowing money, such as fees and compounding. This makes a difference between them.
That said, EAR essentially is an interest rate that is a more precise measurement of the cost of a loan. For example, let’s consider a loan with a nominal rate of 6% versus a simple credit card with the same interest rate. Based on the nominal interest rate, you might think those two options are the same in terms of cost.
APY Formula & Example
We’ll show how to use a formula to calculate APY.
- r – This is the nominal interest rate on a yearly basis
- n – This is the number of periods
Now, let’s consider the following example. Let’s assume a nominal interest rate of 6% and a number of periods of 12. This is the same as our credit card example. Let’s calculate EAR based on this.
Before we start, we need to convert our 6% to decimal numbers. We do this by dividing by 100, 6/100=0.06. You can feed this into our formula.
All we have to do is multiply this by 100 and we’ll get 6.17%.
APY Calculator
Even though the math behind APY is not particularly complicated we could always use the calculator to help us find the result. Let us now consider a different nominal rate. Let’s say we have a nominal interest rate at 5%, and we’ll keep the number of periods the same. If we enter these parameters in our calculator we’ll get the result of 5.12%.
We can clearly see that APY is larger than the nominal interest rate, 5.12 > 5. This happens because of the compounding effect. If we were to pick 1 instead of 12 as our number of periods, what would happen? The result would be 5, exactly the same as the nominal interest rate. Why?
When we have only one payment period per year, there is no compounding. When there’s no compound interest EAR is the same as the nominal interest rate. But as soon as we introduce the number of periods larger than 1, we get the effect of compounding. If n is equal to 2, EAR is then equal to 5.06%. The nominal interest rate in all of these examples is constant at 5%.
In general, it is always a good idea to consider your EAR while making a decision about credit cards and loans. If you are investing money, be sure to calculate APY first. Don’t let the terminology confuse you, it is basically the same thing. If you are thinking about some kind of debt EAR will probably come up somewhere. On the other hand, if you’re thinking of investing, APY is the term you’ll likely find. In any case, it is smart to use EAR/APY when comparing all your options.
FAQs
What’s the Difference Between APY and APR?
The APR is the annual percentage rate of interest, which is a measure of the cost of borrowing money. The APY is the annual percentage yield, which is a measure of how much you will earn on your deposit account.
APR stands for Annual Percentage Rate and it measures the cost of borrowing money. As stated earlier, it is the rate of interest that is charged on an annual basis. APY stands for Annual Percentage Yield and it measures how much you will earn on your deposit account.
It is the total amount of interest you will earn in a year, taking into account the interest that has been added to your account and also any interest that has been earned on your account over the course of the year. The APR rate is expressed as a yearly percentage, while APY represents an annualized percentage yield or compounded yearly return.
What’s a Good APY and How Is It Calculated?
The APY is calculated by taking the interest rate and multiplying it by the number of compounding periods in a year. In fact, you need to use this formula:
APY = (1 + Annual interest rate / Number of periods) ^ number of periods – 1
For example, if your interest rate is 5% and you are compounding monthly, then your APY would be 5.25%. If you had $10,000 invested for 12 months and earned $1,000 in interest, then your APY would be 10%. The higher the annual percentage yield, the better for an investor.
This is because it means that more money will be earned on investments over time. It is worth noting that the APY takes into account compounding interest and the effect of any fees that are deducted from your account.
So, what is a good annual percentage yield? Or in other words, you may want to know what APY value is considered to be good. While the 0.06% APY is the national average savings rate, you can find higher rates in many cases. Online banks boast of the best savings rates come – they are approximately 0.45%.