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.

Definitions for APR and APY

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 

The 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.

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. 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%.

What’s the Difference?

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.

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 two terms 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.

In Conclusion

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.