APR vs. APY: Understanding the Difference
It’s impossible to talk about our finances, loans, or mortgages without coming across terms like interest rate, annual percentage rate, and annual percentage yield. Many people confuse APR and APY or use them interchangeably. While the terms may sound similar, they actually have different meanings.
Both are used to calculate interest. However, one measures the interest paid, while the other measures the interest earned. Understanding the difference between these two terms will help you make better-informed decisions about your finances.
In this article, we’ll explain both terms separately, compare them, and also tell you what they are used for and why you need to know them.
APR vs. APY Definition
Before we can answer the titular question and explain all the differences between APR and APY, we have to define both terms. So, what do these two abbreviations stand for?
Annual Percentage Rate
Annual percentage rate, APR, refers to the yearly interest charged by financial institutions or money lenders when you take out a loan or mortgage. It also applies to money you borrow with your credit cards and personal or home equity lines of credit.
The APR is usually higher than the regular interest rates because it may contain additional fees, but it doesn’t typically include compound interest. However, some credit card companies or issuers may use compounding interest to determine how much they would charge you for your credit.
The difference between the interest rate and APR is that the former is the actual interest the lender expects you to pay for the loan, while the latter includes the interest rate plus additional fees you pay to the lender.
There are several types of APR: fixed, variable, nominal, effective, and credit card APR.
Fixed APR remains the same throughout the length of the loan, and it’s most common when dealing with an auto loan or a mortgage.
Variable APR, on the contrary, can change throughout the life of the loan.
There’s a different credit card APR for each type of credit card balance: purchases, balance transfers, cash advances, and so on.
We can liken nominal APR and effective APR to nominal interest rate vs. APR: Nominal APR refers to the rate stated on your loan, without the cost of obtaining the loan, while effective APR includes additional charges attached to the loan.
Now, how do you calculate APR and see how much interest you’ll accrue? It’s quite simple: The APR is calculated by multiplying the period rate by the number of periods in a year.
Annual Percentage Yield
The annual percentage yield - APY, also called the earned annual interest or effective annual rate - refers to the yearly returns or interests you get when you open a bank account (particularly savings accounts), invest, or buy financial products. APY considers the compound interest gained over a specific period.
Most investment companies and financial institutions advertise high APYs in a bid to attract investors because the higher the APY, the greater your returns. And investors, in turn, look out for opportunities that would yield the best results.
The difference between annual percentage yield and interest rate is that the former compounds the interests gained and adds it to your account over time, while the latter just shows the rate you get for the investment or product. APY is usually higher than the nominal interest rate because it compounds the interest as your money increases periodically.
To calculate APY, use this simple formula:
APY = (1 + r/n)n - 1
R stands for the period rate, and n for the number of compounding periods. For example, if you deposited $500 at 4% interest, with your interest compounded monthly, your APY would be: (1 + 0.04/12)12 - 1 = 0.0407 = 4.07%.
APR vs. APY - What’s the Difference?
So far, we’ve defined both APR and APY to paint a clearer picture of what they are. Here, we’ll compare them and outline the difference between them.
From their definitions, we can see that APR has more to do with the interest you pay when you take out a mortgage or a loan (whether it’s a car, house, school, or personal loan), and it doesn’t take compound interest into account.
APY, on the other hand, is associated with the interest you earn on investment or deposit while compounding your interest gained over a period, typically a year. The longer the investment duration, the greater the percentage yield.
APR vs. APY Example
For example, if you intend to take out a personal loan with a bad credit score, you should know that your credit score will affect the APR. The lower the score, the higher the APR will be. If you take a loan of $10,000 with an APR of 15%, this means you’ll pay the lender $11,500 to settle your debt in full.
This amount could be higher when you take other charges into consideration.
On the other hand, let’s say you invest $10,000 with an APY of 15%. This means that, instead of earning a return of $1,500 ($11,500) after one year, your interest will compound to $1,607.50, increasing your capital to $11,607.50.
Understanding Compound Interest
The difference between APR and APY is easy to grasp when you understand how compounding works.
Compounding is the process of earning interest on your interest. It’s a great tool for increasing wealth over a longer period.
Let’s say you deposit $1,000 into an online savings account with a 24% annual interest rate. This means you get an annual interest of $240, which is $20 monthly (2%).
Without compounding, your total amount at the end of the year would be $1,240. But with compounding, you get $1,020 in the first month, and in the second, you get 2% of your current balance of $1,020, which will be $1,040.4 instead of $1,040. At the end of the year, you get $1,268.20.
APR vs. APY Mortgage Rates
Now let’s take a look at how the annual percentage rate and the annual percentage yield affect mortgage interest rates.
As an aspiring homebuyer, you need to carefully interpret the implications of both APR and APY, together with other factors like your credit score, legal fees, closing costs, and so on, before getting a mortgage to avoid confusion or accepting what you can’t afford.
You need to compare and go for the mortgage plan with the lowest rates because the lower the rates on your mortgage, the lower the amount you’ll pay over time.
The mortgage rate can vary significantly based on whether we’re looking at APR or APY. For instance, if you take out a loan of $10,000 with an APR of 10%, this means you’ll be required to pay an interest of 0.83% monthly ($83.33). The APR for this mortgage will be $1,000, excluding any other charges.
If the mortgage interest rate of this loan were to be compounded, as with APY, the interest rate would have grown over that same period, assuming the borrower was not making their monthly payments. Thus the mortgage rates between APR and APY will be different.
Assuming that the mortgage interest rate is compounded quarterly, 2.5% ($250) of the APR will be added to the initial sum after the first quarter, bringing the sum to $10,250. If the borrower doesn’t make any payments by the end of Q2, 2.5% of $10,250 will be added, making the new loan balance $10,506.25.
By the end of the year, with no payments made, the interest would’ve grown to $13,14.07 (13%), bringing the total sum to $11,314.07.
Here, the loan’s APR is 10%, while the APY is 13%. That’s why it’s essential to understand the rates and terms of your mortgage before making the final choice.
APR vs. APY for Savings Accounts
When opening a savings account, look for an offer with the highest APY and the lowest APR possible. Earlier, we stated that financial institutions tend to advertise high APYs in a bid to get you to open deposit accounts or invest with them. As we know, the higher the APY and the frequency of compounding, the more money you stand to earn over time.
Nonetheless, it’s advisable to look beyond the high APY and see if the APR is also convenient for you should you need a loan in the future. Carefully compare the APR and APY when reviewing multiple offerings before choosing.
However, if you’re primarily interested in the high APY offers and don’t plan on borrowing money in the future, you should know that online banks usually offer high-yield savings accounts with higher APY and lower fees compared to regular banks.
The best part is that these high rates are accessible to all customers, irrespective of their balance tier.
Worthy of note is the fact that the APY on your high-yield savings accounts is variable and may increase or decrease based on market conditions. The Federal Reserve sets the benchmark for this. This means that when the Fed’s interest rate goes up, the APY does too.
APR vs. APY for Investments
Needless to say, before you venture into any form of investment, it is imperative that you fully understand all the terms and conditions of the investment to avoid future complaints or misunderstandings.
At this point, we can all agree that when looking for investment options, our focus should be on the APY rather than the APR. Consider the compounding frequency of the APY. Does it happen daily, monthly, quarterly, or yearly? If the compounding occurs frequently, you’ll earn more money over time.
APR vs. APY for Loans
There are different types of loans, ranging from personal loans to car or auto loans to credit card consolidation loans to student loans, and so on. The requirements for them vary, and so do their interest rates. While some may offer a lower interest rate and require collateral, others may offer a higher interest rate without demanding collateral.
Just like investments, we also need to consider and understand all the terms and conditions that bind a loan before we make our decisions. For loans, focus more on the interest rate instead of APR to calculate correctly the amount you’ll be required to pay as interest for your loan.
The aim is to consider the loans with lower interest rates and APR after weighing in other factors like your credit score and whether or not collateral is involved. Ideally, the interest rates would not be compounded over time, as this would mean you’d end up paying more at the end of the loan duration.
So before you make your final decision, be sure to perform your due diligence and scrutinize every aspect of the loan.
The Bottom Line
In this article, we’ve compared APR and APY in various contexts. Both APR and APY are essential concepts, and an understanding of both will help you manage your finances properly and make informed decisions.
Whether you are investing, lending, or borrowing money, ensure that you compare and understand different quotes offered by financial institutions: There is usually more than what meets the eye when it comes to the offers advertised by most banks.
Your goal should always be to settle for the most favorable option for you.
What does 5.00% APY mean?
We can define APY vs. APR in the following way: APY is the annual percentage yield you get from investing or depositing funds into a savings account or buying final products, which compounds your interest over time.
An APY of 5% means that you get 5% of your investment capital daily or monthly, depending on the agreement. For instance, if you invest $10,000 with an APY of 5% (monthly), this means that, instead of earning a return of $500 ($10,500) after a year, your interest will compound to $607.50, making your total capital to be $11,607.50 in a year. So, in this case, 5% APY will give you $607.50.
Why is APR higher than interest rate?
Earlier, in our interest rate vs. APR comparison, we saw that APR is usually higher than the interest rate because it includes any additional charges that you may be required to pay during the process of taking out a loan or mortgage.
Is APY paid monthly?
Depending on the agreement, APY can be paid daily, monthly, quarterly, or yearly. If it’s paid monthly, your interest will be added to your balance every month and compounded throughout the investment. So you need to pay attention to the frequency because the more frequent your interest compounds, the greater the yield at the end of the period.
How do you convert APR to APY?
So far, we’ve looked at the difference between APR and APY, and perhaps now you are wondering how you can convert one rate to the other.
There are various digital tools and software online that can help you compare, calculate, or convert your APR to APY. Your bank or financial institution can also help you out in this process.
What is better, APR or APY?
There is no right or wrong answer to this question. Whether or not APR is better than APY solely depends on what you intend to gain at the end of the day. We can’t definitively state the better option between APR and APY because it all depends on your standpoint.
If you are a borrower, you may prefer APR to APY because it doesn’t compound the interest to be paid to the lender.
As an investor, you would most likely prefer an investment with APY because it’ll compound your interest rate over time, meaning you’ll earn more.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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