What Is the Annual Percentage Yield (APY)?

The annual percentage yield (APY) is the real rate of return earned on an investment, taking into account the effect of compounding interest. Unlike simple interest, compounding interest is calculated periodically and the amount is immediately added to the balance. With each period going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.

Formula and Calculation of APY

APY standardizes the rate of return. It does this by stating the real percentage of growth that will be earned in compound interest assuming that the money is deposited for one year. The formula for calculating APY is:

Where:

• r = period rate 
• n = number of compounding periods

What Annual APY Can Tell You

Any investment is ultimately judged by its rate of return, whether it’s a certificate of deposit (CD), a share of stock, or a government bond. The rate of return is simply the percentage of growth in an investment over a specific period of time, usually one year. But rates of return can be difficult to compare across different investments if they have different compounding periods. One may compound daily, while another compounds quarterly or biannually.

Comparing rates of return by simply stating the percentage value of each over one year gives an inaccurate result, as it ignores the effects of compounding interest. It is critical to know how often that compounding occurs, since the more often a deposit compounds, the faster the investment grows. This is due to the fact that every time it compounds the interest earned over that period is added to the principal balance and future interest payments are calculated on that larger principal amount.

Comparing the APY on 2 Investments

Suppose you are considering whether to invest in a one-year zero-coupon bond that pays 6% upon maturity or a high-yield money market account that pays 0.5% per month with monthly compounding.

At first glance, the yields appear equal because 12 months multiplied by 0.5% equals 6%. However, when the effects of compounding are included by calculating the APY, the money market investment actually yields (1 + .005)^12 – 1 = 0.06168 = 6.17%.

APY vs. APR

APY is similar to the annual percentage rate (APR) used for loans. The APR reflects the effective percentage that the borrower will pay over a year in interest and fees for the loan. APY and APR are both standardized measures of interest rates expressed as an annualized percentage rate.

However, APY takes into account compound interest while APR does not. Furthermore, the equation for APY does not incorporate account fees, only compounding periods. That’s an important consideration for an investor, who must consider any fees that will be subtracted from an investment’s overall return.

Example of APY

If you deposited $100 for one year at 5% interest and your deposit was compounded quarterly, at the end of the year you would have $105.09. If you had been paid simple interest, you would have had $105.

The APY would be (1 + .05/4) * 4 – 1 = .05095 = 5.095%.

It pays 5% a year interest compounded quarterly, and that adds up to 5.095%. That’s not too dramatic. However, if you left that $100 for four years and it was being compounded quarterly then the amount your initial deposit would have grown to $121.99. Without compounding it would have been $120.

X = D(1 + r/n)n*y

= $100(1 + .05/4)4*4

= $100(1.21989)

= $121.99

where:

• X = Final amount
• D = Initial Deposit
• r = period rate 
• n = number of compounding periods per year
• y = number of years

Special Considerations

Compound Interest

The premise of APY is rooted in the concept of compounding or compound interest. Compound interest is the financial mechanism that allows investment returns to earn returns of their own.

Imagine investing $1,000 at 6% compounded monthly. At the start of your investment, you have $1,000.

After one month, your investment will have earned one month worth of interest at 6%. Your investment will now be worth $1,005 ($1,000 * (1 + .06/12)). At this point, we have not yet seen compounding interest.

After the second month, your investment will have earned a second month of interest at 6%. However, this interest is earned on both your initial investment as well as your $5 interest earned last month. Therefore, your return this month will be greater than last month because your investment basis will be higher. Your investment will now be worth $1,010.03 ($1,005 * (1 + .06/12)). Notice that the interest earned this second month is $5.03, different from the $5.00 from last month.

After the third month, your investment will earn interest on the $1,000, the $5.00 earned from the first month, and the $5.03 earned from the second month. This demonstrates the concept of compound interest: the monthly amount earned will continually increase as long as the APY doesn’t decrease and the investment principal is not reduced.

Variable APY vs. Fixed APY

Savings or checking accounts may have either a variable APY or fixed APY. A variable APY is one that fluctuates and changes with macroeconomic conditions, while a fixed APY does not change (or changes much less frequently). One type of APY isn’t necessarily better than the other. While locking into a fixed APY sounds appealing, consider periods when the Federal Reserve is raising rates and APYs increase each month.

Most checking, savings, and money market accounts have variable APYs, though some promotional bank accounts or bank account bonuses may have a higher fixed APY up to a specific level of deposits. For example. a bank may reward 5% APY on the first $500 deposited, then pay 1% APY on all other deposits.

APY and Risk

In general, investors are usually awarded higher yields when they take on greater risk or agree to make sacrifices. The same can be said regarding the APY of checking, saving, and certificate of deposits.

When a consumer holds money in a checking account, the consumer is asking to have their money on demand to pay for expenses. At a given notice, the consumer may need to pull out their debit card, buy groceries, and draw down their checking account. For this reason, checking accounts often have the lowest APY because there is no risk or sacrifice for the consumer.

When a consumer holds money in a savings account, the consumer may not have immediate need. The consumer may need to transfer funds to their checking account before it can be used. Alternatively, you cannot write checks from normal savings accounts. For this reason, savings accounts usually have higher APYs than checking accounts because consumers face greater limits with savings accounts.

Last, when consumers hold a certificate of deposit, the consumer is agreeing to sacrifice liquidity and access to funds in return for a higher APY. The consumer can’t use or spend the money in a CD (or they can after paying a penalty to break the CD). For this reason, the APY on a CD is highest of three as the consumer is being rewarded for sacrificing immediate access to their funds.

The Bottom Line

APY in banking is the actual rate of return you will earn on your checking or savings account. As opposed to simple interest calculations, APY considers the compounding effect of prior interest earned generating future returns. For this reason, APY will often be higher than simple interest, especially if the account compounds often.

What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.

What Is Annuity Due?

An annuity due is an annuity whose payment is due immediately at the beginning of each period. A common example of an annuity due payment is rent, as landlords often require payment upon the start of a new month as opposed to collecting it after the renter has enjoyed the benefits of the apartment for an entire month.

How Annuity Due Works

An annuity due requires payments made at the beginning, as opposed to the end, of each annuity period. Annuity due payments received by an individual legally represent an asset. Meanwhile, the individual paying the annuity due has a legal debt liability requiring periodic payments.

Because a series of annuity due payments reflect a number of future cash inflows or outflows, the payer or recipient of the funds may wish to calculate the entire value of the annuity while factoring in the time value of money. One can accomplish this by using present value calculations.

A present value table for an annuity due has the projected interest rate across the top of the table and the number of periods as the left-most column. The intersecting cell between the appropriate interest rate and the number of periods represents the present value multiplier. Finding the product between one annuity due payment and the present value multiplier yields the present value of the cash flow.

A whole life annuity due is a financial product sold by insurance companies that require annuity payments at the beginning of each monthly, quarterly, or annual period, as opposed to at the end of the period. This is a type of annuity that will provide the holder with payments during the distribution period for as long as they live. After the annuitant passes on, the insurance company retains any funds remaining.

Annuity Due vs. Ordinary Annuity

An annuity due payment is a recurring issuance of money upon the beginning of a period. Alternatively, an ordinary annuity payment is a recurring issuance of money at the end of a period. Contracts and business agreements outline this payment, and it is based on when the benefit is received. When paying for an expense, the beneficiary pays an annuity due payment before receiving the benefit, while the beneficiary makes ordinary due payments after the benefit has occurred.

The timing of an annuity payment is critical based on opportunity costs. The collector of the payment may invest an annuity due payment collected at the beginning of the month to generate interest or capital gains. This is why an annuity due is more beneficial for the recipient as they have the potential to use funds faster. Alternatively, individuals paying an annuity due lose out on the opportunity to use the funds for an entire period. Those paying annuities thus tend to prefer ordinary annuities.

Examples of Annuity Due

An annuity due may arise due to any recurring obligation. Many monthly bills, such as rent, car payments, and cellphone payments, are annuities due because the beneficiary must pay at the beginning of the billing period. Insurance expenses are typically annuities due as the insurer requires payment at the start of each coverage period. Annuity due situations also typically arise relating to saving for retirement or putting money aside for a specific purpose.

How to Calculate the Value of an Annuity Due

The present and future values of an annuity due can be calculated using slight modifications to the present value and future value of an ordinary annuity.

Present Value of an Annuity Due

The present value of an annuity due tells us the current value of a series of expected annuity payments. In other words, it shows what the future total to be paid is worth now.

Calculating the present value of an annuity due is similar to calculating the present value of an ordinary annuity. However, there are subtle differences to account for when annuity payments are due. For an annuity due, payments are made at the beginning of the interval, and for an ordinary annuity, payments are made at the end of a period. The formula for the present value of an annuity due is:

With:

• C = Cash flows per period
• i = interest rate
• n = number of payments

Let’s look at an example of the present value of an annuity due. Suppose you are a beneficiary designated to immediately receive $1000 each year for 10 years, earning an annual interest rate of 3%. You want to know how much the stream of payments is worth to you today. Based on the present value formula, the present value is $8,786.11.

Future Value of an Annuity Due

The future value of an annuity due shows us the end value of a series of expected payments or the value at a future date.

Just as there are differences in how the present value is calculated for an ordinary annuity and an annuity due, there are also differences in how the future value of money is calculated for an ordinary annuity and an annuity due. The future value of an annuity due is calculated as:

Using the same example, we calculate that the future value of the stream of income payments to be $11,807.80.

Annuity Due FAQs

Which Is Better, Ordinary Annuity or Annuity Due?

Whether an ordinary annuity or an annuity due is better depends on whether you are the payee or payer. As a payee, an annuity due is often preferred because you receive payment up front for a specific term, allowing you to use the funds immediately and enjoy a higher present value than that of an ordinary annuity. As a payer, an ordinary annuity might be favorable as you make your payment at the end of the term, rather than the beginning. You are able to use those funds for the entire period before paying.

Often, you are not afforded the option to choose. For example, insurance premiums are an example of an annuity due, with premium payments due at the beginning of the covered period. A car payment is an example of an ordinary annuity, with payments due at the end of the covered period.

What Is an Immediate Annuity?

An immediate annuity is an account, funded with a lump sum deposit, that generates an immediate stream of income payments. The income can be for a stated amount (e.g., $1,000/month), a stated period (e.g., 10 years), or a lifetime.

How Do You Calculate the Future Value of an Annuity Due?

The future value of an annuity due is calculated using the formula:

where

• C = cash flows per period
• i = interest rate
• n = number of payments

What Does Annuity Mean?

An annuity is an insurance product designed to generate payments immediately or in the future to the annuity owner or a designated payee. The account holder either makes a lump sum payment or a series of payments into the annuity and can either receive an immediate stream of income or defer receiving payments until some time in the future, usually after an accumulation period where the account earns interest tax-deferred.

What Happens When an Annuity Expires?

Once an annuity expires, the contract terminates and no future payments are made. The contractual obligation is fulfilled, with no further duties owed from either party.

The Bottom Line

An annuity due is an annuity with payment due or made at the beginning of the payment interval. In contrast, an ordinary annuity generates payments at the end of the period. As a result, the method for calculating the present and future values differ. A common example of an annuity due is rent payments made to a landlord, and a common example of an ordinary annuity includes mortgage payments made to a lender. Depending on whether you are the payer or payee, the annuity due might be a better option.

What Is the Asset Coverage Ratio?

The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The asset coverage ratio is important because it helps lenders, investors, and analysts measure the financial solvency of a company. Banks and creditors often look for a minimum asset coverage ratio before lending money.

Understanding the Asset Coverage Ratio

The asset coverage ratio provides creditors and investors with the ability to gauge the level of risk associated with investing in a company. Once the coverage ratio is calculated, it can be compared to the ratios of companies within the same industry or sector.

It’s important to note that the ratio is less reliable when comparing it to companies of different industries. Companies within certain industries may typically carry more debt on their balance sheet than others.

For example, a software company might not have much debt while an oil producer is usually more capital intensive, meaning it carries more debt to finance the expensive equipment, such as oil rigs but then again has assets on its balance sheet to back the loans.

Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:

((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt

In this equation, “assets” refers to total assets, and “intangible assets” are assets that can’t be physically touched, such as goodwill or patents. “Current liabilities” are liabilities due within one year, and “short-term debt” is debt that is also due within one year. “Total debt” includes both short-term and long-term debt. All of these line items can be found in the annual report.

How the Asset Coverage Ratio is Used

Companies that issue shares of stock or equity to raise funds don’t have a financial obligation to pay those funds back to investors. However, companies that issue debt via a bond offering or borrow capital from banks or other financial companies have an obligation to make timely payments and, ultimately, pay back the principal amount borrowed.

As a result, banks and investors holding a company’s debt want to know that a company’s earnings or profits are sufficient to cover future debt obligations, but they also want to know what happens if earnings falter.

In other words, the asset coverage ratio is a solvency ratio. It measures how well a company can cover its short-term debt obligations with its assets. A company that has more assets than it does short-term debt and liability obligations indicates to the lender that the company has a better chance of paying back the funds it lends in the event company earnings can not cover the debt.

The higher the asset coverage ratio, the more times a company can cover its debt. Therefore, a company with a high asset coverage ratio is considered to be less risky than a company with a low asset coverage ratio.

If earnings are not enough to cover the company’s financial obligations, the company might be required to sell assets to generate cash. The asset coverage ratio tells creditors and investors how many times the company’s assets can cover its debts in the event earnings are not enough to cover debt payments.

Compared to debt service ratio, asset coverage ratio is an extreme or last recourse ratio because the assets coverage is an extreme use of the assets’ value under a liquidation scenario, which is not an extraordinary event.

Special Considerations

There is one caveat to consider when interpreting the asset coverage ratio. Assets found on the balance sheet are held at their book value, which is often higher than the liquidation or selling value in the event a company would need to sell assets to repay debts. The coverage ratio may be slightly inflated. This concern can be partially eliminated by comparing the ratio against other companies in the same industry.

Example of the Asset Coverage Ratio

For example, let’s say Exxon Mobil Corporation (XOM) has an asset coverage ratio of 1.5, meaning that there are 1.5x’s more assets than debts. Let’s say Chevron Corporation (CVX)–which is within the same industry as Exxon–has a comparable ratio of 1.4, and even though the ratios are similar, they don’t tell the whole story.

If Chevron’s ratio for the prior two periods was .8 and 1.1, the 1.4 ratio in the current period shows the company has improved its balance sheet by increasing assets or deleveraging–paying down debt. Conversely, let’s say Exxon’s asset coverage ratio was 2.2 and 1.8 for the prior two periods, the 1.5 ratio in the current period could be the start of a worrisome trend of decreasing assets or increasing debt.

In other words, it’s not enough to merely analyze one period’s asset coverage ratio. Instead, it’s important to determine what the trend has been over multiple periods and compare that trend with like companies.