Annual Percentage Yield (APY)

Annual percentage yield is a percentage reflecting the total interest a deposit account pays over a year, calculated from the interest rate together with how often interest is compounded. Regulation DD, which implements the Truth in Savings Act, defines it as "a percentage rate reflecting the total amount of interest paid on an account, based on the interest rate and the frequency of compounding for a 365-day period," calculated according to rules the regulation prescribes in an appendix. The underlying statute puts the same idea in concrete terms: the yield is the total interest that would be received on a $100 deposit, given the annual rate of simple interest and the compounding frequency, over a 365-day period.

The point of the figure is comparability. An institution can pay interest monthly, quarterly, daily or once a year, and each choice produces a different amount of money from an identical stated rate. Because the calculation method is set by regulation rather than by each bank, an APY from one institution can be placed beside an APY from another and the higher number is genuinely the better deal on interest. That is the whole reason the measure exists, and it is why federal law requires it rather than leaving banks to advertise whichever percentage flatters them.

Two disclosure rules explain why the reader encounters this figure constantly. Regulation DD provides that if an advertisement states a rate of return, "it shall state the rate as an 'annual percentage yield' using that term," with the abbreviation APY permitted so long as the full phrase appears at least once. An advertised yield must be accompanied by supporting disclosures, including whether the rate is variable, the period the rate is offered, any minimum balance or minimum opening deposit, the effect of fees, and for a time account the term and the early-withdrawal penalty. The account disclosure you receive when you open the account goes further and requires both figures, the annual percentage yield and the interest rate, using those terms. So the pattern is consistent rather than arbitrary: advertisements lead with the yield, and the account paperwork gives you both numbers.

There are in fact two prescribed yield figures with nearly the same name, and a reader who compares them will find they differ. The annual percentage yield is prospective and is what an advertisement quotes. The appendix computes it as 100 multiplied by [(1 + Interest ÷ Principal) raised to the power of (365 ÷ Days in term), minus 1], where Principal is defined as the amount of funds assumed to have been deposited at the beginning of the account. For a 365-day term the formula reduces to 100 × (Interest ÷ Principal). The annual percentage yield earned is retrospective and appears on your periodic statement. It uses the same shape of formula but substitutes the interest actually earned during the period and your average daily balance over that period. The word "assumed" in the first definition is what reconciles them, and the appendix is explicit about what is being assumed: the institution must calculate as though all principal and interest stay on deposit for the whole term and no deposits or withdrawals occur, and for an account with no stated maturity it must assume a term of 365 days. So an advertised yield describes a hypothetical deposit left undisturbed; your statement describes what your own balance did, and a mid-month withdrawal, a deposit, or a fee will move the earned figure without any change in the advertised one.

The disambiguation that saves the most confusion concerns three overlapping labels, and one of them behaves in a way almost no consumer guidance mentions. On borrowing, the annual percentage rate is broader than the interest rate, because it folds certain financing costs in alongside interest, which is why a mortgage APR usually exceeds its quoted rate. On a deposit account the relationship runs the other way. Regulation DD defines the interest rate as "the annual rate of interest paid on an account which does not reflect compounding," and then says that figure "may, but need not, be referred to as the 'annual percentage rate' in addition to being referred to as the 'interest rate.'" The Truth in Savings Act permits the same thing at statute. So on a deposit, APR is a lawful label for the bare nominal rate with compounding stripped out, which puts it below the APY rather than above the rate. Each side of a household balance sheet has an all-in comparison figure; it is called APR on borrowing and APY on saving, and carrying either label across to the other side produces a wrong comparison.

Two further boundaries are worth drawing, because both are live sources of error. An investment yield is a different measure: income as a percentage of what an asset costs or is currently worth, which moves as the price moves. An APY is a compounding-adjusted rate on a deposit and does not move with any price. And an APY is a nominal figure. It adjusts for compounding and for nothing else, so it says nothing about inflation or tax. An account can pay a perfectly respectable yield while the purchasing power of the balance falls, which is the honest thing to say about holding cash and the reason a real, inflation-adjusted return is a separate calculation.

One last exclusion catches people chasing headline offers, and it follows from the definitions rather than from any separate rule. Because the prescribed formula is built from interest, and because Regulation DD defines a bonus as something other than interest, a sign-up bonus falls outside the advertised yield and is disclosed on its own. A quoted APY and the first year's total value are two different quantities. Note finally that Regulation DD applies to depository institutions other than credit unions; credit unions follow the National Credit Union Administration's parallel Truth in Savings rule, which works the same way while speaking of shares and dividends rather than deposits and interest.

The institution takes the interest rate, applies its own compounding frequency, and works out how much a deposit would earn over a 365-day period. That amount, expressed as a percentage of the deposit, is the annual percentage yield. Because the method is prescribed, the arithmetic is reproducible: for a full-year term the yield is simply the interest divided by the principal, times 100.

A hypothetical example, using an illustrative rate rather than any current market rate. Three accounts each hold $10,000 and each states an interest rate of 5%. They differ only in how often interest compounds.

Compounded annually, the account credits interest once, so it earns $500.00 and the yield is 100 × (500 ÷ 10,000) = 5.00%. Compounded monthly, each month earns one twelfth of 5% on a balance that has already grown, so the year produces $511.62 and a yield of 5.12%. Compounded daily, the same process runs 365 times and produces $512.67, a yield of 5.13%.

Three accounts, one stated rate, three different amounts of money. That spread is precisely what the annual percentage yield exists to make visible, and it is why comparing two banks on their stated interest rates rather than their yields can point you at the wrong one.

Now the statement figure. Suppose the monthly-compounding account is Ravi's, and three months in he withdraws $4,000 to cover a repair. The advertised 5.12% has not changed, because it describes an assumed deposit left in place. His statement's annual percentage yield earned will differ, because it is computed from the interest he actually received against his average daily balance for the period, and his average balance was lower than $10,000. Neither number is inaccurate; they are answers to two different questions.

Pros

• One regulated figure makes competing deposit offers directly comparable, which is rarely true of anything else in consumer finance.
• It captures compounding frequency, so a bank cannot make a weaker account look stronger by compounding less often and quoting the nominal rate.
• The calculation method is published, so the figure can be checked rather than taken on trust.
• Any advertisement quoting a rate of return must express it this way and must disclose the conditions attached, including minimum balances and the effect of fees.

Cons

• It is a nominal figure, adjusting for compounding and nothing else, so what a year delivers in spendable, inflation-adjusted terms is always less than the number advertised.
• It excludes sign-up bonuses, so it is not a measure of an account's total first-year value.
• On a variable-rate account the yield is only current. It can change the day after you open the account, and the advertised figure carries no promise about how long it lasts.
• A quoted yield may be conditional on a minimum balance or a qualifying activity, and the headline number is often the best case rather than the one you will get.