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What’s the difference between dividend/interest rate and APY?

The difference between the dividend/interest rate and APY (Annual Percentage Yield) lies primarily in considering compounding. Here’s a breakdown:

Interest Rate

  • Definition: The interest rate is the nominal rate at which interest is paid on the principal amount.
  • Compounding: It does not account for how often interest is compounded. It is simply the rate without considering the effects of compounding within the period.
  • Usage: Often quoted as an annual rate, but it can be applied over different compounding periods (monthly, quarterly, etc.).

Dividend Rate

  • Definition: Similar to the interest rate, but typically used by credit unions or certain investment accounts to describe the rate paid on deposits or investments.
  • Compounding: Like the interest rate, it does not account for the frequency of compounding.

APY (Annual Percentage Yield)

  • Definition: APY reflects the total amount of interest earned on an account in a year, accounting for the effect of compounding interest.
  • Compounding: It includes the effects of compounding, which means it shows the real return on investment or savings over a year.
  • Formula: The formula for APY is:
    APY = (1 + r/n)^n - 1

    where r is the nominal interest rate, and n is the number of compounding periods per year.

Example

Interest Rate/Dividend Rate: If a savings account offers a 5% interest rate compounded monthly, the nominal rate is 5%.

APY: When considering the monthly compounding, the same account will have an APY slightly higher than 5% because the interest earned each month also earns interest in subsequent months.

Key Differences

  • Compounding Effect: APY incorporates the effect of compounding, whereas the nominal interest/dividend rate does not.
  • True Earnings: APY provides a clearer picture of the true annual earnings from an account or investment because it reflects the impact of compounding.
  • Comparison: APY is a better metric for comparing different financial products as it standardizes the impact of compounding across different offers.

In summary, while the interest rate or dividend rate gives you an idea of the annual rate of return without compounding, the APY gives you the actual yearly return, taking into account the compounding of interest.