Annual Percentage Yield (APY) is the term used to express the annual rate of interest on an investment that takes into account the effect of compounding. Normally an investment is sold on the basis of a Nominal Interest Rate, but the nominal rate does not take into account the effect of earning interest on the interest that you earn as you go along.

Compound interest is the process of adding interest earned on an investment account back to the account so that interest is earned on the interest that accumulates plus the principal in the account. To measure compound interest you need to know what the interest rate is and how often the interest is compounded ( added to the account ).

Annual Percentage Yield is different from Annual Percentage Rate (APR.)

The Annual Percentage Rate is the percentage rate that you, a borrower, pay to a financial institution. That interest is paid by you on a monthly basis, and so is calculated differently.

An Annual Percentage Yield is paid to you, an investor, and is based on the concept that interest paid daily must be compounded daily. However, not all APY investments compound daily. Some are compounded monthly or quarterly. Always know how often the investment compounds before making any investment. Obviously, the more often the interest compounds, the higher the return will be since interest paid daily is added to the principal.

Any Annual Percentage Yield is based upon a nominal interest rate, which is the basis of the initial offer of investment.

Annual Percentage Yield is calculated using what is called the Effective Annual Rate formula. APY = (1 + r/n) n – 1 where r is the stated annual interest rate and n is the number of times you’ll compound per year.

You can insert your own variables for the nominal interest rate and the number of times the interest will compound, but as an example, a 6% nominal interest rate-compounding daily will result in an APY of 6.183%.

So, if two Certificates of Deposit (CDs) pay the same nominal interest rate, choose the one that compounds most often. If one CD compounds only at maturity, that CD will have a much lower APY than a CD that compounds daily, monthly, or even quarterly.

Remember also that in order to gain the full effect of compounding you must allow the daily or monthly compounding interest to remain in the investment. Some CD offerings allow you to take monthly payments of the interest earned on a CD. While this may be useful cash to have on hand, you no longer earn interest on that interest.