How does the Annual Percentage Yield differ from the nominal interest rate?

The Annual Percentage Yield (APY) is a critical concept because it provides a more accurate measure of the actual earnings on an investment or deposit over a year, taking into account the effects of compounding interest. This means that APY reflects not only the nominal interest rate but also the frequency of compounding within a year, which can significantly influence the total amount of interest earned.

For instance, if an interest rate is compounded monthly, the interest earned each month will contribute to the principal for the next month’s interest calculation. This compounding effect means that the true yield on the investment or savings account will be higher than the nominal interest rate. Therefore, stating that APY accounts for compounding is correct as it captures the reality of how interest accumulates over time, making it a more useful figure for consumers to understand their potential earnings.

The other options suggest definitions or relationships that do not accurately describe the nature of APY in relation to the nominal rate. For example, APY is typically not a fixed rate, as it can change based on market conditions or the terms of the deposit account. Additionally, nominal interest rates can vary and are not necessarily always higher than APY, especially when compounding methods are considered.