APR vs. APY: Understand the Difference and Why It Matters
Key financial terms like APY and APR can be confusing to interpret, especially when factored into the true cost of borrowing money or the parameters of spending it. Whether you are looking for a high-yield savings account, prime rates or just want to know what happens when you carry a balance on a credit card after the bill due date, an understanding of the fundamentals comes in handy. While some terms may sound similar, knowing the distinction will only better serve your financial goals.
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The Differences Between APR and APY
To break it down, APY is the interest you earn on money stored in a savings account, while APR is the interest charged that you owe when you borrow money from the bank. It’s important to know the difference between these two key terms as they impact your finances, especially when investing or taking out a loan.
APY and APR affect how your interest is ultimately calculated. Knowing the difference between them could help you earn more or owe less money.
APY: This term stands for annual percentage yield and is attributed to how often interest is applied to your balance
APR: This term stands for annual percentage rate and refers to your yearly rate without taking compound interest into account, while APY.
What Is APR?
APR is the total interest paid on a loan over one year, whether that be a credit card or an auto loan. Many factors go into calculating different types of APRs including factoring in whether they are fixed APRs or variable APRs. It can be important to look at credit cards specifically, as there are often different rates for different transactions. Here are some key takeaways:
There could be a separate APR for regular purchases and cash advances.
APRs for mortgage loans may include things like insurance and closing costs.
Read the fine print and ask the bank what is included in the fixed APR being offered and how that APR works.
The higher the APR, the more interest you will pay over the course of that year.
While the annual percentage rate is largely based on the interest rate, some loans also calculate account points, fees accrued and other costs associated with taking out a personal loan.
What Is APY?
APY is the total amount of interest you earn on a deposit account over one year. Unlike APR, annual percentage yield factors in compounding interest. Here are some key takeaways:
Banks are required to display their APYs for each of their accounts, which can be compounded daily, monthly or annually.
The interest earned here is the bank paying you for lending them money.
You can accumulate money faster when you are earning interest on your interest.
APYs are mostly associated with savings accounts, money market accounts and certificates of deposit, or CDs.
Understanding how compounding interest works is essential when it comes to annual percentage yield.
How To Calculate APR and APY
Just as APR and APY mean different things, they are both calculated differently. Remember, the higher the APR, the more interest you pay. The higher the APY, the more interest you are earning.
Calculate APR
The type of credit issued to the consumer determines how APR is calculated. If your loan has a single repayment, you can calculate it in the following steps:
Take the cost of the loan in interest and finance charges and divide it by the amount borrowed or the current balance.
Multiply that number by 365.
Divide the sum by the term of the loan in days.
Example: A $1,000 payday loan with $50 in fees for 14 days:
$50 ÷ $1,000 = 0.05
Then 0.05 x 365 = 18.25
Then 18.25 ÷ 14 = 1.30% APR
Calculate APY
You can certainly calculate APY on your own, but many financial institutions have APY product-specific calculators embedded on their websites for consumers to use. However, you can calculate APY by using this formula:
APY = (1 + r/n)n – 1
The “r” in this equation is the interest rate, and the “n” is the number of compounding periods per year. APYs may look incredibly small, but these small percentages can quickly add up. Make sure to compare APYs across accounts and banks to determine the best potential earnings.
For example, if you deposited $1,000 into an account that compounded daily with a 3% APY, and didn’t put anything else in it for a year, you would have around $1,030.04.
APR vs. APY: What Is Compounding?
Compounding interest is additional interest to the sum of your loan or deposit. Basically, it’s interest on interest. Compound interest can be positive or negative, which depends on if you are earning the interest or paying it. Be aware that APR only shows the annual interest on an account without factoring in compounding interest.
Why Is APY Higher Than APR?
APY is higher than APR depending on how frequently it compounds interest on interest. APR represents the annual rate charged for borrowing money and it includes fees but does not include compounding. On the other hand, APY is how much interest you earn on accounts such as high-yield savings and does take into account compounding
APY vs. APR: What It Means For Crypto
APR is often used to show the interest paid on borrowings in Crypto such as in loans from DeFi applications. However, APY is the return earned from an investment on an annual basis. Crypto often uses APR and APY for both its investments and loans.
Final Take To GO: Comparing the Same Rates
When comparing the same types of rates for certain accounts, always make sure you are comparing apples to apples. Focus on the APY to APY or the APR to APR to get an accurate representation of which account may be best for you.
Online banks typically have more attractive APYs, as they have lower overhead costs. They also tend to have lower maintenance fees and minimum balance requirements, which is often more attractive than the typical brick-and-mortar bank.
Alexandria Bova contributed to the reporting of this article.
This article originally appeared on GOBankingRates.com: APR vs. APY: Understand the Difference and Why It Matters
