What Is APY and How To Calculate It

Wouldn’t it be great if your business’s money started to work for you? While you can’t expect your dollar bills to pack orders and field customer inquiries, the reality is that your cash can earn you more money just by sitting in certain accounts. 

That’s because some business and personal financial accounts provide an annual percentage yield (APY) that rewards you just for keeping a balance there. The more you keep in that account, the more you can earn. 

While the math and terminology behind an APY can get a little complicated, understanding what APY is in banking and other aspects of finance is actually pretty straightforward.

What is APY?

APY stands for annual percentage yield, which means the effective annual return that an account or investment earns. “Effective” means the rate that you’d actually earn if you let your money compound over time, rather than just earning a return on your initial balance. 

This difference reflects the two main types of interest: simple interest and compound interest.

Simple interest

Simple interest is only based on the principal amount. If you deposit $10,000 into a high-yield savings account that pays simple interest at a 6% annual rate, after a year you’d earn $600 and wind up with a balance of $10,600.

Compound interest

Compound interest is based on your balance after accounting for accumulated interest. That means compound interest generally pays more than simple interest. The best way to understand this concept is with numbers.

Suppose you deposit $10,000 into a high-yield savings account that pays interest at a 6% annual rate, but that account pays that interest to you monthly. That means that each month (putting aside that calculations might differ slightly depending on the number of days in a month), you’d earn approximately 0.5% interest. 

So in the first month, your $10,000 would earn $50, meaning your account would grow to $10,050, without having to add money yourself. The next month, due to compound interest, you would earn 0.5% of that $10,050 balance, rather than the initial $10,000. So that would yield $50.25 in interest that month. That extra quarter in interest isn’t life-changing, but the real power of compound interest happens over longer periods of time, not just in a month.

Consider the following simplified chart that shows how compound interest builds over time:

NOTE: Rounding may minimally affect numbers, and ending balance assumes interest is paid out at the end of the month, which may not always be the case in real life.

When you add it all up, after one year, the difference from interest compounding monthly is nearly $17 more than if you just earned simple interest. Again, this isn’t a life-changing amount, but the differences only get larger when increasing the balance, interest rate, compounding frequency (e.g., daily instead of monthly), and time (e.g., multiple years).

So what does this all have to do with APY? 

An annual interest rate generally reflects simple interest, and APY reflects compound interest. Even though these sound similar, the APY is higher than the annual interest rate because it accounts for your balance growing as interest is paid out along the way. As the example above shows, when accounting for compound interest, you’re earning more than 6% per year. To be specific, you’re earning an APY of 6.17%.

APY formula and how to calculate it

The APY formula might look like something that Matt Damon’s character in Good Will Hunting would solve, but it’s less complex than it seems at first glance:

APY = (1 + r/n )n – 1

In this APY formula:

• r = annual rate of return
• n = number of compounding periods in a year

So if the annual interest is 6% (which is 0.06 in decimal form) and there are 12 compounding periods, assuming interest compounds monthly, then the formula would be:

APY = (1+0.06/12)12 – 1

So to calculate this, you would divide 0.06 by 12, which equals 0.005, and then add 1 to get 1.005. Then you would multiply that to the 12th power, meaning you multiply 1.005 by itself 12 times, to get 1.0617. Then subtract 1 to get .0617, which in percentage terms equals an APY of 6.17%, like in the example from the previous section.

The good news is that you usually don’t need to do these full APY calculations yourself. Banks or credit unions tell you the APY for deposit accounts. 

After all, they want to let you know the higher rate you can earn if you let your money compound. If you don’t know the APY but know the simple interest rate and the compounding frequency, search online for an APY calculator. You can plug in the numbers to find the APY. And if you’re still uncertain, ask your financial institution.

What APY tells you

APY tells you how much you’ll earn from an account or investment over a full year. This rate is slightly higher than an annual interest rate without compounding interest. 

For example, a checking account with an APY of 2.5% tells you that after a year, the account balance would grow by 2.5%, e.g., $5,000 would turn into $5,125. Along the way, the actual interest rate might be lower, depending on how often interest compounds, e.g., daily, monthly, or quarterly.

If you know how often interest compounds, you could use an APY calculator or do the calculations yourself to figure out the actual interest rate, such as if you want to know how much interest you’ll earn in a given month. But even if you don’t know the rate that the APY is based on, knowing the APY still gives you a general idea of how much interest you’ll earn at any given time (though remember, the APY is often a little higher than the underlying interest rate).

APY vs. APR: What’s the difference?

In some sense, the inverse of APY is APR, which stands for annual percentage rate. These terms might seem interchangeable, but there are two key differences that end up putting them on opposite sides of the spectrum:

Earning vs. owing

APY tells you how much you’ll earn, such as the effective interest rate you’ll earn from a money market account after accounting for compound interest. In contrast, APR tells you the annual rate that you owe, such as the effective annual interest rates on credit cards or personal loans.

With APY, compound interest works in your favor, and the higher the APY, the better. With APR, compound interest works against you, as interest increases the balance that you’re paying a percentage of each period. And the higher the APR, the more you’ll pay.

Fees

An APR includes fees, while an APY typically does not. For example, if your mortgage includes an origination fee, that could be included as part of the APR calculations to tell you the effective percentage that you’ll be paying on the loan. 

APR is good to know, because when you borrow money, you want to be able to compare the full financing costs, rather than just looking at the amount of principal you have to repay. 

APY also helps you know how much you can earn from a deposit account, but it doesn’t always tell the full story. If your business bank account charges a monthly maintenance fee, for instance, then that cuts into the interest you’re earning. Still, these areas are generally viewed separately and not included as part of APY calculations, so you’ll have to compare these areas on your own to see what makes the most sense for your finances overall.

One way to avoid fees on a business account is to use Shopify Balance, a financial account that has no monthly maintenance or transfer fees already integrated with your Shopify store.* While this account does not accrue interest, it does reward you on the dollar value of deposits maintained in Balance. Your reward is in the form of annual percentage yield (APY). You can earn 3.86% APY rewards based on current rates. The reward accrues daily and is compounded and paid out monthly.**

Shopify partners with Stripe, Inc. and affiliated companies, and financial institution partners, including Evolve Bank & Trust, Member FDIC, and Celtic Bank, to offer money transmission, banking, and issuing services, respectively.

Is APY variable?

APY can be either fixed or variable, depending on the situation. 

For example, certificates of deposit (CDs) typically pay a fixed APY. Some financial institutions also provide fixed APYs for a limited period, such as an introductory fixed APY on a high-yield savings account for six months.

In many other cases, though, such as for standard checking accounts, savings accounts, and money market accounts, the APY tends to be variable, meaning it can change.

APY example

Consider a Shopify store owner who has a Shopify Balance account. Not only does that make it faster to receive a payout from Shopify sales, but you can also earn more money for your business through Shopify Balance APY Rewards, just by keeping cash there.

Note that these rewards are not interest, but the APY concept is the same. Shopify Balance currently provides a 3.86% APY reward, with earnings accrued daily and paid out monthly.2

While the 3.86% APY tells you how much you’d earn on a particular balance after one full year, you can also calculate how much you’d earn each month on a prorated basis after each rewards payout, as well as when the APY changes and when you add money to the account, such as by making more sales.

Consider the following hypothetical scenarios:

From August 1 to October 31, the Shopify Balance account has received $180.85 in APY rewards (though technically the last reward payout would occur on November 5). Note that in the last two scenarios, the first four days are based on a lower balance because rewards from the previous month are deposited on the fifth day of the following month. Rewards accrue daily, and are compounded and paid out monthly. 

Get rewarded for your cash with Shopify Balance

You work hard to make sales, and your proceeds should work hard for you. Instead of depositing all your idle cash in a business bank account where you’re nickeled and dimed while not even earning much—if anything—on your balance, consider putting money into a Shopify Balance account, where you can get rewarded for your cash. 

Earn a current reward rate of 3.86% in the form of an APY just by keeping money within Shopify Balance, while paying no maintenance fees, transfer fees, or any other hidden fees.*

* Shopify Balance has no monthly, transfer, or hidden fees. Shopify doesn’t charge any ATM withdrawal.

** Shopify provides a reward in the form of an annual percentage yield (APY) on the money you hold in Shopify Balance, and it is not interest. The rate is variable and subject to change without notice. The reward accrues daily, and is compounded and paid monthly in the form of a credit to your Balance account.

Shopify partners with Stripe, Inc. and affiliated companies, and financial institution partners, including Evolve Bank & Trust, Member FDIC, and Celtic Bank, to offer money transmission, banking, and issuing services, respectively.