Comparing APR and APY: Unraveling the Mysterious World of Interest Rates

Understanding the Difference Between APR and APY

It's easy to get APR (annual percentage rate) and APY (annual percentage yield) mixed up. While both provide information on how much interest you'll pay or earn, and are expressed as percentages over a 12-month period, there is a key difference between the two. APY takes compound interest into account, giving a more accurate rate of interest. Let's delve deeper into APR and APY to see how they differ in meaning and application.

Key Takeaways

- APY considers compound interest, while APR does not.

- APR is used for advertising loans and credit cards, while APY is used for deposit accounts.

- The more frequent the compounding, the larger the difference between APR and APY.

What Sets APR and APY Apart?

An APR represents the annual percentage rate on a loan or savings product, reflecting the cost someone pays each year to borrow money, including various fees. On the other hand, APY is the "actual rate" someone earns on a balance, considering the frequency of compounding. In essence, APY measures the total interest paid, accounting for compounding. Note that APY can also be referred to as the EAR (effective annual rate).

Borrowing or Earning Amount

Both APR and APY provide information on fees and interest rates associated with borrowing or earning money. A higher APR means more costs over the life of a loan, while APY determines the interest earned or paid, considering the power of compound interest. Lenders typically use APR, which includes fees, when advertising their products, rather than just the interest rate.

Measurement

While both APR and APY measure interest, APR only considers the annual interest rate without factoring in compound interest. The difference between APR and APY increases as interest is compounded more frequently. Financial institutions tend to reference APR more for credit products, like credit cards and personal loans, while APY is commonly used for interest-earning accounts such as savings accounts or CDs.

Choosing Between APR and APY

While APR provides a good baseline for borrowing costs, APY gives a clearer picture of long-term borrowing or saving costs, considering compounding interest. If you plan on carrying a credit card balance for an extended period, APY helps calculate the debt growth over time. Likewise, APY is useful for determining long-term earnings in a CD or savings account.