When you invest or borrow money, it's important to understand how much you're likely to gain or owe. The annual percentage yield, or APY, can be a useful tool in helping you make that determination. The annual percentage yield is the rate of interest that is earned or accrued over the course of a year when accounting for the effect of compounding. It is based on the annual percentage rate and the frequency at which interest on a loan or investment is compounded. The annual percentage yield can give you a better sense of an investment's true return, and of a loan's true cost.
When you borrow or invest money, the total amount of interest you actually wind up paying or earning depends on how often that interest is compounded. Compound interest is interest that's added to the principal amount of an investment or loan so that the additional interest earns interest as well. In other words, compounding is a way of earning or charging interest on interest, and it causes capital gains and debts to grow exponentially.
Compounding can be a good thing or a bad thing depending on whether you're an investor or a borrower. As an investor, compounding is a good thing because it allows you to make money not just on your initial investment, but on the interest it earns. Say you invest $5,000 at an 8% interest rate. After a year, you'll have $5,400 (your initial $5,000 plus $400 in interest). When you go to invest that money the next year, you'll be able to earn interest not only on that $5,000, but on the $400 in interest you already earned.
While compounding can work wonders for investors, it can be a bad thing when you take out a loan, because it increases the amount you eventually wind up paying to borrow money. The more frequently interest is compounded on a loan, the more you'll pay in interest charges over time. If the interest rate is high enough and the interest compounds often enough, then the interest accrued can ultimately be greater than the principal owed.
APY vs. APR
The annual percentage rate, or APR, is the rate of interest you'll earn or owe without taking compounding into consideration, whereas APY is based on compounding. For this reason, when you're looking at a loan or investment, you'll often notice that the APY and APR are different, and the greater the gap between them, the more frequently interest is compounded over the life of the investment or loan.
If you owe money on a credit card, your APY will almost always wind up being higher than your card's listed APR, because interest charges are added to your balance for every month you fail to pay it off. This means that over time, you'll wind up paying interest not only on the principal amount you owe, but on the interest as well.
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