The annual percentage yield (APY) is the actual percentage paid to you when you hold money in an investment for a fixed time. This can be different than the yearly interest rate, and is actually higher when the interest is compounded. Compounding means that you may add interest to your account on a quarterly, yearly, daily or monthly rate.
What happens when compounding occurs is that the money or principal you initially deposit earns interest, then that combined amount earns interest, and so on. If your interest is compounded daily, your annual percentage yield reflects not just the standard rate, but the fact that each time your account balance increases through compounding, you are earning more money. By the end of year, if you have not withdrawn or added money to an investment, your annual percentage yield has increased past the standard rate.
To understand this, it helps to think of the old question as to whether you’d like 100,000 US Dollars (USD) today or a penny invested in an interest-bearing account that doubles each day. If the standard interest rate on the penny is 100% this is not the same as the annual percentage yield. On day two, you have two pennies, on day three, four pennies. Suddenly the percentage yield has jumped to 300% in two days. By day thirty you’d have over a million dollars. Thus the annual percentage yield is much higher than 100%. By the end of the year you’d have more money than you'd know how to spend and the annual percentage yield would be astronomical.
This is why banks or firms that want you to invest with them list the annual percentage yield as well as the annual percentage rate. The percentage yield will increase with the number of times interest is added to your account or compounded. Each time your account increases, the amount of interest you get paid increases and is added to the total. You want to look for investments that compound interest most often, since the APY will be higher.
People sometimes confuse the APY with the annual percentage rate (APR). The main difference is that the APR usually refers to money loaned to you. Here, too, it is wise to know how often the money you owe is going to be compounded and added to the interest you’ve accumulated on your loan. Depending on when and how often the money you owe is compounded with interest, you could end up paying a much higher percentage rate on your loan than if interest is only compounded yearly. Knowing the APR is valuable when you want to borrow money. When borrowing money, look for the opposite features of the annual percentage rate. Find loans that compound the least often, and investments that compound most often to respectively save money or make it.