So, you are planning to transfer your savings to a bank account right now, but you are confused about dividend rate vs APY. Some banks use dividend rate, while some others use APY. Even though both dividend rate and APY are designed to provide you a return on an initial amount of money, dividend rate and APY are actually two very different things. One of the differences is that dividend rate is usually used to describe an income payment for an investor, whereas APY is a return given for a deposit account. Let’s take a look at the workings and mechanisms of dividend rate and APY below.
What is the Dividend Rate?
A ‘dividend’ is a distribution of a portion of the earnings of a company to a class of the company’s shareholders, and it is decided by the board of directors. In this general sense, a dividend can be issued in the form of cash payments, stock shares, or other property. In the more specific sense, however, a dividend is given to you for keeping your money in a bank account, and it is determined by a percentage of your total balance.
The dividend rate is a total amount of the expected dividend payments from a particular investment, fund, or portfolio. It is expressed on an annual basis, and it may also receive additional non-recurring dividends that are received in the specific period. Of course, different companies may have different preferences and strategies, which is the reason why a dividend rate can be either fixed or adjustable.
For a bank account, dividends are usually paid on a monthly basis. For every month, you are paid that particular month’s portion of your annual dividend according to a specific equation.
Calculating the Dividend Rate
The fundamental difference between dividend rate vs APY is the ways they calculate their numbers. A monthly dividend payment is calculated by multiplying the dividend rate with the average balance and the number of days in the month per the number of days in the year. Here is the written equation:
Monthly Dividend Payment = (days in the month / 365 days in a year) * (average balance) * (dividend rate)
For example, if your bank account earns a 2.24% annual dividend and you have an average balance of $10,000 in January, you will earn a monthly dividend payment of (31 / 365) * ($10,000) * (2.24%) = $19.02.
You may have noticed that, by using that equation, you can actually earn dividends on dividends. In the first month, you will earn a dividend on your balance. In the next month, you will earn a dividend on the original balance plus the dividend previously earned in the prior month. You see, dividends on dividends. This is called the compounding effect. You will actually earn more than the percentage of your initial sum of money. The compounding effect has the potential to give you much greater returns over the long run, as the cycle continues throughout the life of the bank account until the money is withdrawn.
For example, if we continue the example above for the month of February, you will earn a monthly dividend payment of (28 / 365) * ($10,019.02) * (2.24%) = $17.22. If we calculate all the dividend payments until December and calculate the total, you will actually get a total of $226 for your initial $10,000 – which is higher than if one simply multiplies the 2.24% dividend rate to the initial balance. In the next year, you will start with $10,226, and the dividend payments will be even greater.
On the other hand, Annual Percentage Yield (APY) is a percentage value that represents how much you are going to earn from an investment or deposit while considering the compounding effect. In other words, the difference between dividend rate vs APY is that dividend rate does not consider the compounding effect whereas APY has it considered.
In an investment scenario, rate of return is just an amount by which an investment grows after a period of time, although it is indeed expressed as a percentage to be calculated with the initial investment amount. However, rates of return are difficult to compare across different investment vehicles, especially if the vehicles to be compared have different compounding periods. One investment vehicle may compound interest monthly, another quarterly, and others annually or biannually. Comparing these rates of return would be inaccurate because such action ignores the compounding effect. APY solves the problem by standardizing each rate of return by adjusting the rate of return into an assumption of a one-year compounding period.
APY is calculated by the following equation:
APY = (1 + periodic rate) #periods – 1
The resultant percentage has an assumption that the money will remain in the investment cycle for a full year. APY is actually quite similar to APR, which is often used for loans, except that APY does not consider account fees. Its usefulness is in its ability to standardize varying interest rates into an annualized percentage.
Now, for the example, suppose that there are two options presented to you right now: a one-year zero-coupon bond that gives 6% upon maturity and a high-yield money market account that gives 0.5% per month with monthly compounding. At first, they seem to be similar because 0.5% multiplied by 12 months equals to 6%.
However, if we consider the compounding effect of the second option by calculating the APY, it can actually yield (1 + 0.005)12 – 1 = 0.0617 = 6.17%. As you can see, it is actually the better option. An investment that offers an interest rate of 6% divided by 365 days with daily compounding will give you an even higher APY percentage.
|- A total of the expected dividend payments from your balance||- A percentage value that represents how much you are going to earn from your balance|
|- Does not consider the compounding effect||- Has considered the compounding effect|
|- The actual total amount that you get can be higher than the initial percentage||- The actual total amount is the same as the initial percentage|
|- Easier to calculate||- Easier to compare across different bank accounts|
There is no straight-forward answer whether dividend rate vs APY is better. You have to calculate the numbers to really see which bank account provides the best benefit. The dividend rate is a total amount of the expected dividend payments from your balance. It does not consider the compounding effect, so the total amount that you get can be higher than the initial percentage. On the other hand, APY is a percentage value that represents how much you are going to earn from your balance while considering the compounding effect.