The terms APR and APY are often confused because they calculate interest for investment and credit products. They significantly affect how much you earn or must pay when applied to your account balances.
For starters, annual percentage yield (APY) takes into account compound interest, but annual percentage rate (APR) does not.
Understanding Compound Interest
Mankind’s greatest invention is reportedly compound interest, according to Albert Einstein.
It’s important to understand how compound interest applies to investments and loans, whether you agree or not.
Compounding refers to earning or paying interest on previous interest, which is added to the principal sum of a deposit or loan.
All investors want to minimize compounding on their loans and, at the same time, maximize it on their investments. The difference between compound interest and simple interest is that the latter results from multiplying the daily interest rate by the number of days between payments.
APR
Since APR makes it seem like borrowers will end up paying less on loans, mortgages, and credit cards in the long run, financial institutions often tout their credit products using APR.
APR does not take into account the compounding of interest within a specific year; it is calculated by multiplying the periodic interest rate by the number of periods in a year in which the periodic rate is applied. The sentence does not indicate how often the rate is applied to the balance.
APR is calculated by taking the number of days in the year, dividing it by the number of days in the term, and then multiplying it by the interest rate.
APR is calculated as follows:
APR = Periodic Rate x Number of Periods in a Year
APY
Investment companies generally advertise the APY they pay to attract investors because it seems like they’ll earn more on things like certificates of deposit (CDs), individual retirement accounts (IRAs), and savings accounts. APR doesn’t consider the frequency with which the interest is applied—the effects of intra-year compounding. This seemingly subtle difference can have important implications for investors and borrowers. APY is calculated by (1+ the periodic rate as a decimal)^ the number of times equal to the number of periods that the rate is applied -1
Here’s how APY is calculated:
APY = (1 + Periodic Rate)Number of periods – 1)
APR vs. APY Example
The APR for a credit card company that charges 1% interest each month equals 12%. APY takes into account compound interest, whereas this does not.
The APY for a 1% rate of interest compounded monthly would be 12.68% a year. If you only carry a balance on your credit card for one month, you will be charged the equivalent monthly rate of 1%. Due to compounding each month, your effective interest rate for carrying a balance on your credit card for a year is 12.68%.
The Borrower’s Perspective
When looking at the difference between APR and APY, you need to be concerned about how a loan might be disguised as having a lower rate. APY stands for annual percentage yield, and another term for it is earned annual interest (EAR), which factors in compounding interest.
Although the quoted rates for a mortgage appear low, you could end up paying more for the loan than you originally anticipated and end up choosing a lender that offers a higher rate.
Banks will usually quote you the annual percentage rate on a loan; however, this number does not consider any intra-year compounding of the loan, whether it be semi-annually, quarterly, or monthly. The APR is the periodic rate of interest multiplied by the number of periods in the year.
Let’s look at an example to solidify the concept, as this may be a little confusing initially.
| APR vs. What You Actually Pay | |||
|---|---|---|---|
| Bank Quote APR | Semi-annual | Quarterly | Monthly |
| 5% | 5.06% | 5.09% | 5.11% |
| 7% | 7.12% | 7.19% | 7.23% |
| 9% | 9.20% | 9.30% | 9.38% |
Depending on the frequency of compounding, you may pay a much higher rate than a bank quotes you. For example, if a bank quotes an APR of 9%, the figure isn’t considering the effects of compounding. If you were to consider the effects of monthly compounding, as APY does, you would pay 0.38% more on your loan each year—a significant amount when you amortize your loan over a 25- or 30-year period.
When seeking a loan, you must ask your potential lender what rate they are quoting.
The Lender’s Perspective
Now, as you may have already guessed, it is not hard to see how standing on the other side of the lending tree can affect your results equally significantly. Just as those seeking loans want to pay the lowest possible interest rate, those who are lending money (which is what you’re technically doing by depositing funds in a bank) or investing funds want to receive the highest interest rate.
You want a bank that offers the best rate of return on your hard-earned dollars when shopping around for a savings account. It is in the bank’s best interest to quote you the APR, which includes compounding and, therefore, will be a sexier number, as opposed to the APY, which doesn’t include compounding.
You should take a hard look at how often compounding occurs at the bank you are considering and compare that to other banks’ APY quotes with compounding at an equivalent rate. It can significantly affect the amount of interest your savings could accrue.
The Bottom Line
The greater the difference between APR and APY, the more frequently the interest compounds. Mind the rates quoted when shopping for a loan, signing up for a credit card, or seeking the highest rate of return on a savings account.
Financial institutions quoted different rates depending on whether you are a borrower or lender. Always compare rates from other institutions after ensuring you understand which rates they are quoting. You may be surprised to see that the lowest advertised rate for a loan can turn out to be the most expensive.
