The last time you read the fine print for debt or investment products you were interested in or possessed, you may have run across the acronyms APR or APY. But what exactly do they mean? Why do some financial institutions use one over the other? And how do you tell the difference between the two? Are they calculated the same?
Read on to learn the answers to these questions and much more with regards to APR and APY.
APR: An Overview
Also known as the Annual Percentage Rate, APR is the interest rate or cost of borrowing assessed by the creditor on your debt. It’s also referred to as the return that can earn on your savings, but it does not account for compounding interest.
The formula for computing the APR on debt or savings products is as follows:
- APR = Periodic Rate X Number of Periods Per Year
So, if your investment of $25,000 earns an APR of 4 percent, compounded annually, the interest earned in the first year will be $1,000. And at the end of the year, the balance of the investment account will be $26,000.
You can also use an online calculator, as the one found here, to find the solution.
APY: An Overview
Also known as the effective annual rate, APY is the Annual Percentage Yield assessed by creditors or earned on savings, and it accounts for compounding interest.
The formula for computing the APY on debt or savings products is as follows:
- APY = [(1 + Periodic Rate Express as a Decimal)^Number of Periods] – 1
But if this seems a bit too complex, use an online calculator like the one mentioned above that works both ways, to find the solution.
A Closer Look at the Key Difference Between APR and APY
Whether you’re discussing APR or APY, both refer to the one of the following:
- Interest paid on a loan or debt product
- Interest paid on a savings or investment product such as a savings account
However, the key difference lies in the compounding of interest. While APY accounts for compounding interest, APR does not. But what does this mean?
Compounding Interest, Explained
Interest is compounded on a daily, monthly, quarterly, or annual basis. So, if your credit card provider compounds interest daily, the balance used to calculate how much you pay in interest will change each day, even if you don’t make any additional purchases.
Why so? Well, the credit card company will calculate the interest charge on day one by multiplying the balance by the rate. But on day two, the balance that is multiplied by the rate will include the interest accrued on day one. In other words, you’ll be paying interest on interest until the card is paid off.
To illustrate with a starting credit card balance of $500 and APY of 24 percent compounded monthly:
|Month||Starting Balance||Compounded||Interest Assessed
(.24/12) = .02 monthly
|New Outstanding Balance|
|1||$500||Monthly||$500 * .02 = $10||$510|
|2||$510||Monthly||$510 * .02 = $10.20||$520.20|
|3||$520.20||Monthly||$520.2 * .02 = $10.40||$530.60|
|4||$530.60||Monthly||$530.6 * .02 = $10.61||$541.21|
|5||$541.21||Monthly||$541.21 * .02 = $10.82||$552.03|
|6||$552.03||Monthly||$552.03 * .02= $11.04||$563.07|
|7||$563.07||Monthly||$563.07 * .02= $11.26||$574.33|
|8||$574.33||Monthly||$574.33 * .02= $11.49||$585.82|
|9||$585.82||Monthly||$585.82 * .02= $11.72||$597.54|
|10||$597.54||Monthly||$597.54 * .02= $11.95||$609.49|
|11||$609.49||Monthly||$609.49 * .02= $12.19||$621.68|
|12||$621.68||Monthly||$621.68 * .02= $12.43||$634.11|
Using the same figures, if interest is compounded annually at an APR of 24 percent, the total interest charged for the year would be $120, compared to $134.11 in this example.
An Important Note: the APY will be higher if interest is compounded daily, monthly, or quarterly. However, the APR and APY figures may be the same if interest compounds annually.
Which One Do Companies Use?
The Case for APR
When applying for a credit card or loan, creditors are more likely to advertise the APR because it conveys to the consumer that they’ll pay less in interest than they actually will, particularly if the interest compounds monthly or daily. In this case, you’ll want to convert the APR to APY to figure out exactly how much you’re paying in interest for the year.
The Case for APY
Because compounding interest is factored into the APY, it’s more appealing to advertise this rate instead of APR to prospective investors. Why so? Well, it’s higher than the APR rate since APR on accounts for annual earnings and APY accounts for monthly, daily, or quarterly earnings, depending on how the financial institution compounds interest on the investment product.
The Bottom Line
To get a solid idea of how much you’ll be paying or earning in interest on debt or investment products, it’s best to understand how both the advertised APR and APY are calculated. Most importantly, when comparing the prospective costs or returns, be sure to analyze the same type of rate (i.e. APR or APY) to make an informed decision.