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If you go to apply for a credit card or loan, or open a savings account, a bank is probably going to throw a bunch of acronyms and finance lingo at you. And, sometimes, customers just sign away without considering the financial implications of their quick decision.
Annual percentage rate (APR) and annual percentage yield (APY) are used frequently in these instances and are important to both savers and borrowers, and it’s easy to confuse the two. Learning the difference 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.
What is APR?
APR represents the cost of borrowing money annually, typically in the form of 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, takes into account the interest rate, along with fees and other charges. This is different from the interest rate alone, as it includes all of the fees and other costs associated with your total amount.
The Consumer Financial Protection Bureau (CFPB) states: “The Annual Percentage Rate (APR) is the cost you pay each year to borrow money, including fees, expressed as a percentage.” This usually takes interest rates, lender fees, insurance, and other related fees into account. This could mean that the APR and the interest rate are the same, which is mostly the case for credit cards. However, since the APR could include costs like lender fees, this rate will be more useful than the interest rate when comparing offers for loans, credit cards, and different financing options.
The “annual” part of the annual percentage rate unfortunately doesn’t mean that you only pay these costs on a loan or credit card once a year. It’s most likely the case that you pay it monthly or have a more routine payment, depending on the loan. An important thing to remember is if the APR is significantly higher than the interest rate, you are paying a lot of extra fees. Your goal is to always aim for a low APR because the lower the APR, the less you are going to pay in the end.
One of the biggest things to note with APR is that it doesn’t consider compound interest. While APR does include many fees, it doesn’t include everything. APR is advertised as the true cost of borrowing, but that’s not always completely accurate and will likely be lower than the amount you are required to pay back each year.
How to calculate APR
If you’re borrowing money or saving money and the bank advertises both APY and APR, it’s important to do the math to see how they compare. The formula for APR looks a little different than the one for APY.
The formula for APR works like this:
APR = Fees + Interest/Principal/Number of days in the loan term 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. This is something you can use an online calculator to do.
What is APY?
APY is the interest you earn on interest-bearing accounts. Examples include savings accounts, money market accounts, certificates of deposit, and more. That’s a simple explanation, so let’s dig a little deeper. First, let’s look at the APY a traditional savings account might offer.
When you open a savings account to build your emergency fund or sinking fund, for example, the bank might give you two numbers to consider. One is the interest rate, and the other is the APY. The interest rate is just what it sounds like: a set percentage rate of interest you earn on the money you keep in your account.
APY, on the other hand, is a way of measuring how much you can earn on savings, based on how often your interest rate compounds. Compounding basically means earning interest on your interest, along with the interest you earn on the principal amount in your account. More on that in a minute.
Compounding interest can be particularly powerful when it comes to investing in something like an individual retirement account (IRA) or your 401(k). The longer your money compounds, the more wealth you can build, especially when you’re using automatic savings deposits to add to the principal.
How to calculate APY
The formula used to calculate APY is a lot different than the one for APR.
Calculating APY works like this:
APY = (1 + r/n)n – 1
If that seems a little complicated, don’t worry. Just know that “r” stands for interest rate, and “n” stands for the number of times the interest is compounded per year. You can easily use an APY calculator as well, instead of crunching the numbers yourself. Essentially, what you need to know is the interest rate you’re earning and how often it compounds to see how much your money can grow.
What does compound interest mean?
Compound interest is the money that you make off of interest. You might be thinking, “Wait…what?” That’s a totally normal reaction! Compound interest can be viewed as a good or bad for your finances. It’s good when you’re earning money on your balance. This is often the case for savings accounts or other investment accounts where you hold a large amount of money and earn interest on how much is in that account.
It can be bad when you have a loan or other type of debt with compounding interest. The balance you have to pay back is then growing, forcing you to pay more money the longer you have the debt. This is common with student loans, personal loans, mortgages, and credit cards.
Here’s an example to illustrate how APY and APR can make a difference with your money, especially when it comes to compound interest.
Assume that you want to invest $10,000 in a savings account with a 5% APR and a 5% APY. Knowing that APY compounds monthly, after 1 year, here’s how much interest you would earn based on both APY and APR:
Now, that doesn’t seem like a huge difference. But compound interest is really a long-term game. So, let’s assume that you left that same $10,000 in a savings account earning 5%, and you let it compound for 5 years. Even if you don’t make any new deposits, your balance would grow to $12,833.59. Over 30 years, it would increase to more than $44,000, all thanks to compound interest.
By comparison, if you were just measuring interest earned using APR, your account balance would be just $25,000 after that 30-year mark. That’s because with APR, your money doesn’t benefit from the power of compounding interest over time. You’re just earning a set amount of interest each year. From a saving or investing perspective, it’s APY — not APR — that’s going to be your best friend.
Again, keep in mind that 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.
APR vs. APY
APR and APY are two important terms to understand regarding interest rates, but one is not better than the other as they are used very differently. To sum it up, APR determines how much it costs you to borrow money, and APY, on the other hand, defines how much interest you can earn on your savings and how fast your money adds up.
Knowing the APR before you get a loan or credit card can help you shop around for the best deal. And here’s one more important thing to know about APY vs. APR. With APY, the bank sets interest rates based on a benchmark interest rate, such as 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. The better your credit score, the lower your interest rate and the more money you save on interest.
What’s the difference between APY and EAR?
EAR stands for “effective annual rate.” EAR calculates compound interest and 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. On a credit card, for example, carrying a balance month over month will increase the EAR, resulting in a higher rate than what was initially advertised. Also, EAR is driven by the number of compounding periods in a year. When you take out a loan, for example, 12 compounding periods will always result in a higher EAR than a loan that compounds quarterly.
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.
When interest compounds more frequently, you may experience the following:
- The balance of your savings or investment account may grow.
- The owed balance on your loan or credit card may increase.
Will my APR or APY rate change?
Whether or not your interest rates will change typically depends on whether you’re dealing with a fixed rate or a variable rate. With a fixed interest rate, your APR or APY is unlikely to change. However, 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.
How do I get an APR or APY from my bank?
Some banks and financial institutions offer a higher APY if you keep higher balances in your account. Shopping around and comparing rates from different banks — both online and in-person — may also help you land a better rate.
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 is the best option 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 APY to compare savings products. This way, when you are making important decisions in life, you are well-prepared and know your stuff!