Both annual percentage rate (APR) and annual percentage yield (APY) describe the interest associated with either an investment or loan. Essentially, the difference boils down to this — APR is the rate charged for borrowing or earned through an investment while APY is the effective rate of return, considering compounding interest. The two values vary for different financial products. Whether you’re socking away money in a savings account or a money market account, buying bonds or paying off a credit card balance, it’s important to understand the distinction between the two. Below, we take a closer look at how APR and APY work, and how they differ.
What is APR?
When taking out a loan, a lender will charge you a percentage of the principal amount. This is known as the interest rate. APR is quite similar because both involve interest, but the interest rate and APR do have notable differences. For one, the interest rate represents the percentage the lender may charge on a loan, while APR represents the annual amount of interest paid a loan. The APR value also includes the fees associated with taking out a loan. The figure doesn’t include compound interest, and it takes into account periodic rate. You’ll commonly see APR with things that involve credit, such as mortgages or car loans. And borrowers should note that lenders determine what interest rate to offer for a loan.
Additionally, there are different types of APR, but the two most common are fixed-rate APR or variable APR. While fixed-rate APRs remain constant throughout the term of your loans, variable rate APRs don’t. These APRs change as a loan’s index interest rate changes — a change which can be linked to the U.S. prime rate. And the relationship between the index rate and the APR is direct, so if one increases so does the other. But there’s also another type of APR to be aware of — penalty APR. Credit card issuers may double your APR rate if you default on a payment for more than a certain number of days. This would raise your interest rate, increasing the amount you’d owe.
What is APY?
APY represents a combination of your yearly interest rate and the rate at which your interest compounds. Compound interest is basically interest you’ve earned both from your money in an account and that money’s interest. The compounding rates may be daily, monthly, quarterly or yearly. Then the amount of compound interest you earn is added onto the principal sum of your deposit or loan. You’ll usually have an APY for financial products like certificates of deposit (CDs), savings or money market accounts. Because there’s a direct relationship between the APY and your finances, you’ll earn more money with a higher APY rate. Additionally, you’ll earn more with interest that compounds daily, as opposed to a monthly or quarterly compounding rate.
For instance, with an initial deposit of $25,000, with an interest rate of 1.50% over a 180 day term, you’d earn around $25,185.37, assuming your interest compounded monthly. For the same deposit amount, interest rate and term, you’d earn roughly $25,185.49 if your interest compounded daily, according to an APY calculator.
What’s the Difference Between APR and APY?
APR and APY differ in that the former doesn’t include compounded interest, while the latter does. Your APY value represents your deposit’s interest plus compound interest. The APR value, on the other hand, only includes interest and fees associated with your loan.
Additionally, APY can either be the amount of interest you pay off, or the amount of interest you earn. If you’re depositing money into a CD, savings account or money market account, you’ll be earning money with interest. If you’re paying off a credit card balance, however, your final balance will include compound interest. In the case of savings accounts, you’ll benefit from a higher APY. But with credit card balances, a lower APY will save you money.
How to Calculate APR vs. APY?
To calculate APR, you’d multiply the daily periodic rate by the number of periods in a year. For instance, if your issuer charges you interest each month, you’d have 12 periods in a year. For an interest rate of 3.7%, you’d multiply that value by 12. With APY, however, you’d raise the periodic rate plus one to the power of yearly periods minus one. If you’d rather not calculate the APR or APY, you can also determine your either value through an online calculator.
Whether you’re investing in an account or paying off a loan, APR and APY can significantly affect your finances. For investments or savings accounts, a higher APY will typically earn you more money, and your money will grow even faster depending on the rate at which your initial deposit compounds. But for loans and debt, a higher APY will cost you more. If for some reason you miss a payment on a loan, a lower APR is better than a high one. You’ll also want to note the additional fees included in your yearly APY value. Whether they’re loan origination fees or other costs, they’ll ultimately affect your final balance. In addition, factors such as loan term, initial deposit and interest rate all affect your rate of growth or debt, so you’ll want to keep these in mind before you proceed.
Tips for Saving on Interest
- One of the best ways to save money is to meet your loan payments on time. If you’ve got a remaining balance on your credit card, you’ll have to account for the extra money that may result from a high APR and APY rate. But if there’s an emergency where you have to miss your payment’s due date, it’s better to have a lower APR and APY rate. If both values are higher, you’ll spend more making up the debt. It may also be useful to look for credit cards with low APRs, so if you ever miss a payment deadline, you won’t lose as much.
- If you’re new to investment and savings accounts, or if you’d like expert advice on credit cards or loans, a financial advisor could be right for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/SARINYAPINNGAM, ©iStock.com/marchmeena29, ©iStock.com/Stígur Már Karlsson /Heimsmyndir