Investing comes with a lot of options. While risk bearers might go to the stock markets, risk-averse investors may adopt a conservative approach and move towards fixed-income instruments. They usually invest money in deposit accounts and provide a fixed percentage of returns. However, to actually measure the returns from these avenues, the annual percentage yield (APY) is used. Let’s define APY and see how is APY calculated. Continue reading to learn more about APY.
What is the Annual Percentage Yield?
As the name suggests, APY is a measure of the annual yield that a particular asset may generate. Annual Percentage Yield meaning usually denotes the percentage of returns that the investor may generate income from deposit accounts like fixed deposits, savings bank accounts, recurring deposits, etc. APY calculates the yield in terms of an entire year. This helps facilitate comparisons between different assets and makes informed investment decisions possible.
How Does APY Work?
After discussing APY meaning, let’s see how it exactly works. As stated earlier, APY calculates the annual yield for one year. However, it is not necessary that the interest or returns on your asset are received only once a year. For instance, most savings bank accounts provide a return quarterly.
Therefore, the depositor does not only receive interest on the principal amount but also on the interest portion. This is known as compounding, i.e., interest on the principal and the interest component.
APY takes compounding into account to provide you with the actual yield that you earned over a period of one year. For understanding this, we need to check the formula of APY.
Formula and Calculation of APY
For calculating APY, the following is the mathematical formula that you should use:
APY = (1+ r/n)n – 1
where,
r = annual rate of interest
n = number of compounding periods for each year
In the above formula, "n" depicts the number of compounding periods that show how APY considers compounding while calculating the yield returns. Let’s see some practical illustrations to understand how the annual percentage yield is calculated:
Example-1: Mr. Q has deposited Rs. 10,000 in a deposit account with a bank. The bank will be providing an interest @ 8% per annum compounded quarterly. Mr. Q wanted to know the APY of his deposit.
Solution: For calculating the APY, Mr. Q shall use the following formula:
APY = (1+ r/n)n – 1
Therefore, (1+ 0.08/4)4 - 1
= 8.24% per annum
Thus, in a year, Mr. Q will be effectively earning 8.24% on his deposits.
This is how to calculate APY interest. In the next example, let’s see how it can affect your financial decisions.
Example-2: Suppose Mr. Q gets two offers to deposit Rs. 10 lakhs for a period of 10 years. One offer provides an 8% interest rate compounded monthly, whereas the second offer provides an 8.1% interest rate compounded half-yearly. Mr. Q wants to go for a second offer considering a higher interest rate but is confused about the compounding aspect. Where should he invest?
Solution: Let’s check the APY of both options over a period of 10 years:
Thus, it can be seen that even though Offer-B is offering a higher interest rate, the compounding effect offered by Offer-A is providing higher absolute returns than Offer-B.
While Offer-A will provide a return of Rs. 12,19,640 over the period of 10 years, Offer-B will provide a return of Rs. 12,12,288. Thus, Offer-A provides Rs. 7352 more in terms of interest than Offer-B.
This is because of the compounding benefit that Offer-A is providing, whereby interest will accrue to Mr. Q each month. Therefore, effectively, Mr. Q will be earning an interest rate of 8.30% per annum in Offer-A against 8.264% per annum in Offer-B.
How APY is Different From Interest Rate?
After discussing what APY means and how to calculate APY, it is important to know that APY and the interest rate are different. Most investors confuse the APY and the interest rate in the sense that both the APY and the interest rate represent interest returns to the investors. Therefore, what is the difference between both of them?
Let’s understand the same:
Annual Percentage Yield
Interest Rate
It is a measure of yield, i.e., the returns that the investor actually earned in a particular year.
It is a measure of interest that the deposit scheme is providing to the investor.
It considers compounding accounts.
It is only a simple interest and does not take compounding into account.
This is useful when there are quarterly rests, i.e., interest is paid more than once during the year.
Useful when interest is paid only once during the entire year.
Here comes the interesting question – Can APY and interest rates be the same?
The answer is yes! If the interest is paid only once during the entire year, then the interest rate will be the APY for the depositor.
Whether the Interest Rate on Loans Similar to the APY?
After discussing the annual percentage yield definition, it can be concluded that APY is a signifier of the returns on deposit that a depositor earns. However, a pertinent question arises as to whether the APY also signifies the interest that borrowers pay on loans. Well, it is to be noted that the interest paid on loans is denoted by the Annual Percentage Rate (APR) and not APY.
The method for how calculating annual percentage yield is different from the APR calculation. Borrowing involves multiple charges aside from the interest rate. This includes origination fees, discount fees, administrative charges, etc. APR considers both the interest rate as well as other charges to determine the true charges that the borrower will be paying.
In a Nutshell
APY definition and calculation show that it is the true significator of the actual returns that a depositor can earn each year considering the compounding benefit. If a depositor wants to calculate APY, he can use an online APY calculator.
Depositors just need to enter the deposit amount, interest rate, compounding frequency, and tenure of the deposit. It will calculate the APY, the total investment value at the end of the investment term, as well as the total interest earned by the depositor. APY allows depositors to make informed investment decisions, as Mr.Q did in the above example.
TATA Capital is a financial and investment service provider that not only offers multiple financial and personal loan products but also helps investors and borrowers make informed financial decisions. For more useful information and details, visit the TATA Capital website now!
29 November 2022
6 mins read
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