Financial institutions understand how to advertise both APR and APY in a way that will attract more customers. So, whether you’re considering a new credit card, a savings account, or even a mortgage, it’s important to understand what these terms mean and how they work.
APR and APY are similar in that they both refer to interest rates for certain financial products. Beyond that, however, the two terms have little in common. From the products they are associated with to their relationship with compound interest and surcharges, APR and APY are as opposite as goats and boats.
Annual interest rates and annual interest rates are determined
Simply put, APR indicates money owed and APY indicates money earned.
APR stands for Annual Interest Rate and APY stands for Annual Interest Rate (also called Effective Annual Interest Rate or EAR).
What is the difference between APR and APY?
Products they are associated with
Because the APR is applied to borrowed money, you usually see it associated with products such as credit cards, home and auto loans, or lines of credit.
Because APY refers to the money you earn, the term is most commonly associated with products such as savings accounts, certificates of deposit (CDs), and investments.
Link to the simple interest rate
When you look at an APR for a home or auto loan, it usually includes the interest rate as well as some additional fees and costs. For example, the APR on a mortgage may include closing costs and lender fees.
On the other hand, APY does not include additional fees because it is in the interest of the bank to make this number look as high as possible. However, APY is also different from the simple interest rate, but for a different reason: compound interest.
Compound interest
As explained above, lenders want to advertise low APR and high APR to attract more potential customers. When you understand this motivation, the relationship between these numbers and compound interest makes sense.
In short, compound interest refers to interest paid on interest. For example, interest accrues on the principal amount of a loan over time. At the end of the day, these interest add up, which means you will pay interest on the principal amount plus any accrued interest.
With that said, when a lender lists APR for a personal loan or credit card, they won’t take compound interest into account because they want the lowest possible rate. However, with APY, the opposite is true. High APY means more profit for the client, so this number does include compound interest.
Connected: The power of compound interest
How to calculate APR and APY?
First of all, you don’t need to know how to calculate APR and APY. There are many free online calculators that will do this step for you (including a number of our own free calculators).
However, the formulas below can help you figure out what each of these percentages goes into so you can better understand how they affect your finances.
Calculation of annual
To calculate the annual interest rate on a loan, you will need the following information: expected loan fees, total loan interest, loan amount and number of days in the loan term. Once you’ve collected these numbers, plug them into the following formula:
[((Fees + Total interest) / Loan amount) / Number of days in the loan term) x 365] x 100 = per annum
The formula may seem too complicated, so let’s break it down with a real-life example. You are considering a six-month loan (180 days) of $4,750. Expected fees are $70 and total interest is $500. Here is what the completed APR formula would look like:
[(($70 + $500) / $4,750) / 180) x 365] x 100 = 24.3%
Read more: Loan repayment calculator
Calculation of the annual interest rate
If you want to calculate APY for a new savings or investment account, you need to know the interest rate and how often that rate is compounded throughout the year. Here is the formula for calculating APY:
[(1 + (interest / number of compounding periods)^compounding periods] – 1 = APG
When you plug in these numbers, keep in mind that the interest rate must be written as a decimal. For example, let’s say you put $1,000 into a savings account for 12 months. Interest is calculated monthly and your interest rate is 1%. Here is what the APY formula would look like in this scenario:
[(1 + (0.01 / 12)^12] – 1 = 1.004%
Are APR and APY really that important?
When you’re comparing loan products or savings accounts, remember that seemingly small numerical changes can make quite a difference in how much you owe or earn over time. To illustrate the importance of these subtle differences, take a look at the scenarios below.
Annual interest rate comparison
Let’s say you need to replace the engine in your car, which will cost $5,000. You don’t have all that cash right now, so you’ll have to pay off your purchase over time. Your current credit card has a 23% APR. According to the Money Under 30 Credit Card Interest Rate Calculator, this card will charge $644.58 in interest if you pay off a $5,000 purchase within a 12-month period.
But given what a savvy consumer you are, you decide to check out competing low-interest credit cards before buying a new engine and are offered 18% APR on another card. Making a purchase with this card at a lower APR will result in only $500.80 in interest.
In other words, an annual interest rate that is only 5% lower means additional $143.78 what’s in your pocket.
Read more: Understanding the Annual Percentage Rate (APR)
APY Comparison
It’s been a few years and you’ve diligently saved up some money for an emergency fund that will allow you to pay cash whenever you have a problem with your car and not pay outrageous credit card interest rates at all.
Your regular bank has a savings account offering 0.25% per annum. If you deposit $10,000 into this account and leave the money to earn interest over the next five years (no further contributions), you will earn $125.77 in interest according to our Savings Interest Calculator.
But when comparing high-yielding savings accounts, you notice that a new digital bank has emerged offering 1.25% per annum. In this APY, your savings will accumulate $644.60 in interest over a 10-year period. A “total” difference of 1% results in an additional $518.83 you would save!
Summary
APR and APY sound the same and are both related to percentage; however, the similarity between the two terms ends there.
APR and APY are associated with completely different financial products. One takes into account compound interest and the other does not. Even the size of the number can mean completely different conclusions to a potential client; for one, a higher value is preferable, and for another, a lower value is better.
When you’re estimating APR or APY for a particular product, it’s important to understand not only what those numbers represent, but also how subtle rate differences will play out over time.
