By JLP | October 12, 2006
Have you ever wanted to know how to convert a stated interest rate to an Annual Percentage Yield (APY)? If so, read on because you’re in for some real excitement!
First off, we need to understand what the Annual Percentage Yield (APY – from now on I’ll refer to it as “APY”) is. Say a bank is offering a savings account that is paying 5% annually. If you opened an account and deposited $100 and left it there without touching it, how much would you have at the end of one year? One would think you would have $105 since 5% of $100 is $5, which is true. However, most banks compound interest daily, which means that you are earning interest on top of interest. So, your $100 would actually be worth $105.13, which gives you an APY of 5.1267%. I know, it’s not the big of a difference, but over the long run the difference can add up.
There is a formula that you can use to convert an interest rate to an APY. It’s not that hard to use. It looks like this:
r = interest rate
n = the number of compounding periods
So, using the numbers from above, the formula looks like this:
Now we know why banks like to quote APY since it looks better!
If you aren’t interested in computing that yourself, you can use this Conversion Calculator I put together. It is a very simple calculator but gets the job done. And for those who are interested, you can also download my Bank Savings Account Tracker (Excel Spreadsheet) that will allow you to estimate how much a savings account will be worth in a one-year time period based on deposited amount, timing of the deposits, and interest rate. Enjoy!