What does compounding interest affect when considering APY?

Compounding interest directly influences the effective annual rate of return on an investment, which is reflected in the Annual Percentage Yield (APY). APY represents the real rate of return on an investment, taking into account the effect of compounding over a year. When interest is compounded, it means that the interest earned in previous periods is added to the principal amount, leading to interest calculation on an increased total. As a result, investments that compound interest more frequently will have higher APYs, signifying a greater effective annual rate of return compared to those that do not. This makes understanding APY crucial for investors evaluating potential returns on their savings or investments, as it gives a more accurate depiction of growth than just the nominal interest rate alone.