Rate vs. APY Calculator
Convert nominal interest rates to Annual Percentage Yield based on compounding frequency.
Understanding Nominal Rate vs. APY
When comparing financial products like savings accounts, CDs, or even loans, you will often encounter two different percentage figures: the Nominal Interest Rate and the Annual Percentage Yield (APY). While they sound similar, the difference can significantly impact your earnings or costs over time.
What is the Nominal Rate?
The nominal rate is the "stated" annual interest rate of a financial product. It does not take into account the effect of compounding within the year. For example, if a bank offers a 5% nominal rate, that is the base rate used to calculate interest in each period.
What is APY?
The Annual Percentage Yield (APY) is the "effective" annual rate. It reflects the total amount of interest paid on an account, based on the nominal interest rate and the frequency of compounding. Because compounding adds interest back into the principal balance, the APY is almost always higher than the nominal rate.
The Mathematics of Compounding
The formula used to calculate APY from a nominal rate is:
APY = (1 + r/n)^n – 1
- r = Nominal Interest Rate (as a decimal)
- n = Number of compounding periods per year
Example Comparison
Imagine you have $10,000 in a savings account with a 4% nominal interest rate. Let's look at how the compounding frequency changes your APY and total return after one year:
- Annual Compounding: APY is 4.00%. You earn $400.00.
- Monthly Compounding: APY is 4.07%. You earn $407.41.
- Daily Compounding: APY is 4.08%. You earn $408.11.
While the nominal rate stays at 4%, the APY shows you that daily compounding actually earns you more money than annual compounding.
Why This Matters
Banks are required by law (specifically the Truth in Savings Act in the US) to disclose the APY on deposit accounts. This provides a standardized way for consumers to compare products with different compounding schedules. When you are the one earning interest (savings), you want the highest APY. When you are the one paying interest (loans/credit cards), you should look at the APR (Annual Percentage Rate), which is calculated differently but serves a similar comparative purpose.