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APR vs. APY: what’s the difference?
APR stands for annual percentage rate and calculates the interest charges you must pay to borrow money. APY stands for annual percentage yield and refers to the interest rate you can earn on money you deposit.
If you apply for a credit card or a loan or open a savings account, you might see a bunch of acronyms and finance lingo in the terms and conditions. Sometimes, customers sign up for cards or accounts without considering the financial implications of their decision.
Annual percentage rate (APR) and annual percentage yield (APY) are used frequently in these instances and are crucial to both savers and borrowers. It’s easy to confuse the two considering how similar the acronyms are. Learning the difference between APR vs. APY can help you manage your finances and make you wiser when you borrow money.
With that in mind, here’s what APR and APY stand for and the key differences.
APR represents the cost of borrowing money annually, typically through loans or credit cards. It’s the extra money you will pay each year on that loan, such as your mortgage, car payment, or credit card.
The APR for a loan or credit card, for instance, considers the interest rate, fees, and other charges. This differs from the interest rate alone, as it includes all the fees and other costs associated with your total amount.
The “annual” part of the annual percentage rate doesn’t mean you only pay these costs on a loan or credit card once a year. Depending on the loan, you’ll most likely pay it monthly or have a more routine payment.
If the APR is significantly higher than the interest rate, you are paying many extra fees. Aim for a low APR because the lower the APR, the less you will pay.
APY is the interest you earn on interest-bearing accounts like savings accounts, money market accounts, and certificates of deposit. More specifically, the APY measures how much you can earn on savings based on how often your interest rate compounds.
With compounding interest, you earn interest on the current amount in your account, which can include interest you’ve already earned.
How to calculate APR and APY
The formulas for calculating APR and APY also differ.
The formula for APR works like this:
APR = ((Fees + interest Rate/Principal loan amount/Number of loan term days) x 365) x 100
Written our with variables, it looks like this: APR = ((F + R)/P/N) x 365) x 100
To figure out APR using the formula above, you need to know the interest rate on the loan, the fees you’re paying, the principal balance, and the number of days in the loan term.
Calculating APY works like this:
APY = ((1 + (interest Rate/Number of times interest is compounded yearly)) raised to the power of Number of times interest is compounded yearly) – 1
Written out with variables, it looks like this: APY = (1 + R/N)n – 1
To determine the APY, you need to know the interest rate you’re earning and how often it compounds to see how much your money can grow.
You can also use an APY calculator instead of crunching the numbers yourself.
What's the difference between APR vs. APY?
APR determines how much it costs you to borrow money, and APY defines how much interest you can earn on your savings and how fast your money adds up.
Another important detail about APY vs. APR: with APY, the bank sets interest rates based on a benchmark interest rate, like the federal funds rate. With APR, rates are typically based on a benchmark like the prime rate, but the actual rate you end up with hinges largely on your credit score.
What does compound interest mean?
Compound interest is the money you make from interest or the interest that grows on a loan you owe.
Compound interest is commonly associated with savings accounts or other investment accounts where you hold a large amount of money and earn interest on your account balance.
On the other hand, loans or other types of debt can also compound interest. The balance you have to pay back then grows, forcing you to pay more money the longer you have the debt. This is common with student loans, personal loans, mortgages, and credit cards.
For example, you want to put $10,000 in a savings account with 5% APY. Assuming your APY is compounded monthly, you’ll end up with $10,511.62 in a year. If you let it compound for five years, your balance would grow to $12,833.59 even without making additional deposits. Over 30 years, it would increase to more than $44,000, all thanks to compound interest.
The interest you could earn can vary based on how much you deposit into your account, how often and how much you put in or take out, and the type of account you open.
Understanding APY and APR can help your financial health
APY and APR might seem confusing at first glance. The most important thing to know is how they affect you financially when you borrow or save and which option is best for you.
When trying to assess how much you’ll pay to borrow or how much interest you could earn on a savings account, keep it simple. Use APR to compare loans or credit cards and use APY to compare savings account options.
What’s the difference between APY and EAR?
EAR stands for effective annual rate and calculates compound interest. It is usually a more accurate representation of the cost of borrowing money over time, whereas APR is typically the introductory rate for a loan or credit card.
How often does interest compound?
Depending on the terms of your loan, savings account, or investment account, interest may compound daily, monthly, or quarterly. Some accounts may also compound yearly.
Will my APR or APY rate change?
Your APR or APY is unlikely to change with a fixed interest rate. If you have a variable rate, as in the case of most credit cards, you should expect changes in your interest rates alongside market changes and economic fluctuation.
Why is APR higher than APY?
APR typically includes other charges like lender fees and the interest rate, so it can be higher than the APY.
Which is better, APR vs. APY?
Neither is better since APR and APY measure different things. APR looks at what you could be paying for a loan; APY looks at how much you can earn in interest.
20% APY would equal 18.37% APR.