Financial institutions understand how to advertise both APR and APY in ways that attract more customers. So whether you’re considering a new credit card, a savings account, or even a home loan, it’s important to understand what these terms mean and how they work.
APR and APY are similar in that both refer to interest rates for certain financial products. Beyond this, however, the two terms have little in common. From the products they’re associated with to their relationships with compound interest and additional fees, APR and APY are as opposite as goats and boats.
APR and APY Defined
In the simplest terms, APR indicates money owed, while APY indicates money earned.
APR stands for Annual Percentage Rate, and APY stands for Annual Percentage Yield (also called an effective annual interest rate, or EAR).
How Do APR and APY Differ?
Products They’re Associated With
Because APR applies to money borrowed, you’ll typically see it associated with products like credit cards, home and auto loans, or lines of credit.
Since APY applies to money you’re earning, the term is most often associated with products like savings accounts, certificates of deposit (CDs), and investments.
Relationship with Simple Interest Rate
When you’re looking at the APR for a home or auto loan, it will generally encompass the interest rate as well as some additional fees and costs. For instance, the APR for a mortgage may take into account closing costs and lender fees.
APY, on the other hand, does not include extra fees, since it is in the bank’s best interest to make this number look as high as possible. However, the APY also differs from the simple interest rate—but for another reason: compound interest.
As explained above, lenders want to advertise a low APR and a high APY to appeal to more prospective customers. When you understand this motivation, the relationship between these numbers and compound interest makes perfect sense.
In short, compound interest refers to interest paid on interest. For example, your loan principal accrues interest over time. Eventually, that interest compounds, which means you’ll pay interest on the value of your loan principal plus any interest accrued.
With this said, when a lender lists the APR for a personal loan or credit card it won’t take compound interest into account, because they want to feature the lowest possible rate. With APY, however, the opposite is true. A high APY means greater returns for the customer, so this number does include compound interest.
Related: The Power of Compound Interest
How Do You Calculate APR and APY?
First of all, you don’t really need to know how to calculate APR and APY. There are plenty of free calculators available online that tackle this step for you (including a number of our own free calculators).
Nevertheless, the formulas below can help you learn what is included in each of these percentages, so you can better understand how they affect your finances.
To calculate a loan’s APR, you’ll need the following information: anticipated loan fees, the loan’s total interest, the loan amount, and the number of days in the loan term. Once you’ve gathered these numbers, plug them into the following formula:
[((Fees + Total interest) / Loan amount) / Number of days in the loan term) x 365] x 100 = APR
The formula may seem overwhelming, so let’s break it down into a real world example. You’re considering a six-month loan (180 days) for $4,750. The anticipated fees are $70, and the total interest is $500. Here is what the filled-out APR formula would look like:
[(($70 + $500) / $4,750) / 180) x 365] x 100 = 24.3%
Read more: Loan Payoff Calculator
If you’d like to calculate the APY for a new savings or investment account, you’ll need to know the interest rate as well as how frequently that rate compounds in a year. Here is the formula for calculating APY:
[(1 + (interest / number of compounding periods)^compounding periods] – 1 = APY
When you plug these numbers in, keep in mind that the interest rate should be written as a decimal. For example, let’s say you deposited $1,000 into a savings account for 12 months. The interest compounds monthly, and your interest rate is 1%. Here is how the APY formula would look in this scenario:
[(1 + (0.01 / 12)^12] – 1 = 1.004%
Are APR and APY Really That Important?
When you’re comparing credit products or savings accounts, remember that seemingly small numerical changes can amount to some pretty significant differences in how much you owe or earn over time. To help illustrate the importance of these subtle differences, take a look at the scenarios below.
Let’s say you need to replace the engine in your car, which will cost $5,000. You don’t have all that cash available right now, so you’ll have to pay off the purchase over time. Your current credit card has a 23% purchase APR. According to Money Under 30’s Credit Card Interest Rate Calculator, that card would charge $644.58 in interest if you pay off the $5K purchase over a 12-month period.
But, given what a savvy consumer you are, you decide to check out competing low-interest credit cards before you buy the new engine, and you’re offered an 18% APR for a different card. Making the purchase with that lower-APR card would result in only $500.80 in interest charges.
In other words, an APR that’s just 5% lower translates to an extra $143.78 that you pocket.
Read more: Understanding Annual Percentage Rate (APR)
A few years pass, and you’ve diligently saved up some money for an emergency fund, which will allow you to pay cash whenever you have car trouble and skip the gouging credit card APR charges altogether.
Your usual bank has a savings account offering 0.25% APY. If you put $10,000 into that account and leave the money to sit and accrue interest over the next five years (with no further contributions), you’ll earn $125.77 in interest per our Savings Interest Calculator,
But when comparing high-yield savings accounts you notice that there’s a new digital bank offering a 1.25% APY. At that APY your savings would accrue $644.60 in interest over a 10-year period. ‘Just’ a 1% difference results in an extra $518.83 you’d save!
APR and APY sound alike and are both associated with interest; however, the similarities between these two terms stop there.
APR and APY are associated with entirely different financial products. One considers compound interest, while the other does not. Even the size of the number can signify dramatically different conclusions for a prospective customer; for one, a higher value is preferable, but for the other, the lower the better.
When you’re evaluating the APR or APY for a specific product, it’s important to understand not only what these numbers represent, but how subtle differences in a rate will play out over time.