Annual percentage yield (APY) refers to how much interest you earn on savings and takes compound interest into account. Annual percentage rate (APR) focuses on how much interest you'll pay for money you've borrowed. The terms are often confused because both are used to calculate interest for investment and credit products. Both significantly affect how much you earn or must pay when they're applied to youraccount balances.
Key Takeaways
- APR represents the yearly rate charged for borrowing money. It includes fees but not including compounding.
- APY refers to how much interest you'll earn on savings and it takes compounding into account.
- The difference between APR andAPY increases as interest is compounded more frequently.
- Banks and investment companies generally advertise the APY. Lenders advertise APR.
Annual Percentage Rate (APR)
Annual percentage rate (APR) is the interest you pay on a credit card or other loan plus any fees. APR is a more accurate representation of what you pay over a year compared to simple interest because it includes fees. Federal law requires that lenders share their APRs with consumers to help them compare rates and shop for loans.
The APR for a mortgage loan includes:
- Interest rate
- Any points (the interest rate reduction for an upfront fee)
- Mortgage broker fees
- Other loan-related charges and fees
APR does not account for compound interest if you don't pay off the borrowed money. Compounded interest is earning or payingintereston previous interest. This is added to the principal sum of a deposit or loan.
APR is calculated by multiplying theperiodic interest rate by the number of periods in a year in which the periodic rate is applied:
APR = [((Fees + Interest/Principal)/n) x 365] x 100
- Interest = Totalinterestpaidoverthe lifeoftheloan
- Principal = Loanamount
- n = Numberofdaysinloanterm
The Truth in Lending Act (TILA) mandates that lenders disclose the APR they charge to borrowers. Credit card companies are allowed to advertise interest rates every month. They must report the APR to customers before they sign an agreement.
Annual Percentage Yield (APY)
Annual percentage yield (APY) shows the interest you'll receive over a year from certificates of deposit (CDs), money market accounts, and savings accounts. Like APR, federal law requires financial institutions to disclose the APY so you can shop around for the highest APY. However, APY doesn't reflect any bonuses that may be provided and special rules apply to accounts with variable APY or tiered APYs.
APYincludes a calculation of how compounded interest impacts the interest rate over one year. Your savings increase faster due to compounded interest. You'll earn more if your interest compounds more frequently. The easiest way to calculate potential earnings from APY is to use an online compounding calculator.
You can calculate APY yourself by adding 1 to the periodic rate. Divide that number by the number of compounding periods then raise that result by the number of periods the rate is applied. Subtract 1 from that number.
APY = [(1 + r/n)n] – 1
Where:
- r = periodic rate
- n = number of compounding periods
APR vs. APY: An Example
You take out a short-term personal $5,000 loan with an APR of 5%. Interest compounds monthly but you're constantly paying down the balance with equal payments. You repay roughly $428.04 per month divided into 12 payments. You'll repay $136.45 in interest over one year.
Now imagine putting $5,000 into a 12-month CD with a 5% APR. The interest compounds monthly so your APY would work out to 5.116%. You'll earn $255.81 at the end of the year if you don't remove any of the CD's funds during that time.
The CD's interest return is higher because your money grows monthly and you're not removing any of it. You're reducing the principal and interest that interest is charged on the loan, even though the interest is still compounding.
The Borrower's Perspective
As a borrower, you always search for the lowest possible rate, hoping to pay less to borrow money. For instance, when you're shopping around for amortgage, you're likely to choose alenderoffering the lowest rate.
Banks often quote you the annual percentage rate on the loan or credit card. But, as we've already said, this figure does not consider intra-yearcompounding of the loan if you don't pay it off. It can compound daily, semi-annually, quarterly, or monthly.
Let's look at an example to solidify the concept.
| 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% |
A bank may quote you a loan's interest rate of 5%, 7%, or 9% depending on the compounding frequency but you may pay a much higher rate. The quoted figure doesn't account for the effects of compounding but it does account for fees and other costs.
Suppose you were to consider the effects of monthly compounding asAPYdoes. You will pay 0.38% more on your loan each year in this case, a significant amount when you amortize your loan over a 25- or 30-year period as you would with a mortgage.
It's important to compare apples to apples when you're considering different borrowing prospects. Compare the same types of figures so you can make the most informed decision.
The Saver's Perspective
You'll want to receive the highest interest rate and benefit from frequently compounded interest if you're lending money, what you're technically doing when you deposit funds in a bank, or when you're investing funds,
Let's suppose that you're shopping around for a high-yield savings account. You want an account offering the bestrate of returnon your hard-earned dollars. Take a hard look at how often compounding occurs along with when your account is credited. Then compare the compounded APY to other banks'APYquotes with compounding at an equivalent rate. Itcan significantly affect the amount of interest your savings could accrue.
Which Is Better, APR or APY?
Both are helpful when you're shopping for rates and comparing which is best for you. APY helps you see how much you could earn over a year in a savings account or CD. APR helps you estimate how much you could owe on a home loan, car loan, personal loan, or credit card.
What Is a Good APR Rate?
A good APR rate is a low APR rate. You can review the Federal Reserve's current averages to compare an APR offered for a new car loan, personal loan, or credit card. But remember that the APR offered to you may depend on your credit score and other factors. Compare similar products whether you're shopping for credit cards or home loans. Compare cash-back card APRs to other cash-back card APRs.
What's the Difference Between an Interest Rate and APY on a CD?
The interest rate is the simple interest earned on your CD account's balance. A CD's APY is the interest you'll earn over a year, including compounded interest, as long as you don't withdraw any of your earnings.
The Bottom Line
Both APR andAPYcan help you manage your personal finances. The more frequently the interest compounds, the greater the difference between APR andAPY. Be mindful of the different rates quoted whether you're shopping for a loan, signing up for acredit card, or seeking the highestrate of returnon a savings account.
Financial institutions may have different motives for quoting different rates depending on whether you're a borrower or a lender. Always make sure you understand which rates are quoted and then look at comparable rates from other institutions.
Correction—Feb. 6, 2024: This article has been edited to reflect that the 12-month CD example was based on a 5% APR.
Article Sources
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