Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
APR and APY can be confusing financial concepts, but knowing the difference between the two ways to calculate annual interest can help you make more informed decisions when saving and investing. Both APR and APY affect how much you earn or owe when applied to account balances.
APR vs. APY: Defined
APR stands for annual percentage rate. It’s the annual rate of interest paid on a loan. But, its calculation does not account for any compounding of the interest during the year. So, it’s the interest rate if you don't account for how often that rate is applied to the balance during the year.
APY stands for annual percentage yield. Unlike APR, APY is takes into account any compounding done during the year such as daily or monthly compounding. Some products, like credit cards, actually compound interest daily. APY reflects the periodic interest rate and the frequency at which it’s compounded during a 365-day period.
A saver is generally looking to get paid a higher interest rate on their investment. A bank or credit union has more incentive to show you the APY on its deposit accounts like certificate of deposits, instead of the APR because the APY is generally higher.
A borrower is generally looking for the lowest possible rate they can pay to borrow on a mortgage, personal loan, credit card or what have you. When you’re borrowing, a lender has more incentive to advertise using the APR rather than APY on the product so that you, the borrower, get the sense you’re paying the lender less than you actually will pay in interest.
How compounding works:
Compounding is when interest is charged or paid on top of the existing balance plus interest that has already accumulated.
“This is a powerful tool for an investor, but a crushing reality for a debtor with credit card or other consumer debt,” Justin Harvey, president and founder of Philadelphia, Pa.-based Quantifi Planning, told Deposit Accounts.
When interest compounds on debt, it hurts because it means you wind up owing much more than your original balance.
When it comes to saving and investing, however, compounding interest is your friend. Let’s say you earn 5% on $1,000 ultimately netting a $50 return. If you decide to re-invest the $1,050 ($1,000 plus the $50 you earned in interest the first time around), you end up with a balance of $1,102.50.
The $52.50 earned in interest on round two was the result of 5% being applied to $1,050, instead of the $1,000 originally invested. If you were to re-invest the $1,102.50 at a 5% return rate a third time, you’d get $1,157.63 and so on.
“The interest on interest may not seem much at first, but the impact is very significant over long periods of time,” Justin Choy, a portfolio analyst with Frisch Financial Group, told Deposit Accounts. “It’s similar to a snowball rolling down a hill. Over time, the snowball gets bigger and the rate of which it’s getting bigger also gets faster.”
What types of products use APR?
Financial products used for borrowing generally advertise an APR. That includes financial borrowing products repaid with interest like personal loans, lines of credit and credit cards.
“When borrowing money, APR also accounts for other costs associated with obtaining that loan, not just interest,” said Choy.
Those costs may include loan origination or underwriting fees that increase the overall cost of your loan.
How to calculate APR
To calculate APR, you’d take the periodic interest rate (the interest rate at the time of compounding) and multiply it by the number of times the periodic rate is applied during a 365-day period. The equation is as follows:
APR = periodic rate * number of periods in a year
So, if a credit card company charges a 24% APR and compounds interest daily as credit cards often do nowadays, that’s akin to charging 0.066% interest each day.
24% APR = 0.066% periodic rate * 365 periods
What types of products use APY?
Investments that offer a fixed return like deposit accounts generally advertise an annual percentage yield or APY. That group includes financial products that earn a return for savers like savings and checking accounts, certificate of deposit accounts and money market accounts.
How to calculate APY
To calculate APY, you’d take into account compounded interest, so the equation is a little different. You would take the periodic interest rate as a decimal, add 1, then multiply it by itself the number of periods the rate is applied. When you get that number, subtract 1 to get the APY.
The equation is as follows:
APY = ((1+ decimal form of periodic rate) ^ number of periods in a year) - 1
27.23% APY = (1+ .00066) ^ 365 periods in a year - 1
Understanding APY is valuable when you’re comparing investments that offer a fixed return like deposit accounts. If you’re trying to figure out the total amount of interest you can earn on a CD or money market account, for example, you’ll want to use APY, as it accounts for each time interest is compounded on the balance.
Why is it important to know the difference between APR vs. APY?
The difference between the two rate calculations is important to know when you are comparing borrowing options. When you compare financial products, Harvey advises borrowers make sure to compare apples to apples — APY to APY and APR to APR — to calculate the best deal for you.
You can use both calculations to see what you’re really paying to borrow, and understand how the periodic interest rate is applied to a loan.
“I recommend calculating APY whenever possible because the differences may be larger than you think,” said Choy.
It’s important to remember the APY calculation adds more interest since the interest is applied to a larger balance each period.
“The more frequent the compounding, the greater the differential between the APR and the APY,” said Harvey.
With a periodic rate that compounds annually, the APY will equal the APR, whereas with a periodic rate compounded daily (like credit cards and other debts often do), the APY may be 2% to 3% higher than the APR.
When the difference between APR vs. APY matters:
Although borrowing products generally advertise an APR, the interest rate may be compounded periodically, so it may be worth it to you to calculate the APY, too.
For example, if you take out a 5-year personal loan for $10,000 at 5% APR including fees, you might not notice that the periodic interest rate (5% APR/12 = 0.42%) is applied on each monthly payment. When applied to 12 periods in a calendar year, you actually end up paying back 5.12% in interest, or $10,512 instead of $10,500.
The $12 may not seem like much in the grand scheme of things. But if your goal is to save money, it’s worth calculating the total amount of interest you’d pay over time when comparing loans.
Harvey advises consumers generally calculate the APY using daily compounding — the most frequent interval possible aside from intraday compounding — for debts like mortgages and credit cards.
Why compounding isn’t realistic with revolving loans.
Trying to keep up with the APR shown on your terms and the actual APY you may pay at year’s end on a revolving loan like a credit card may be futile.
For example, most credit cards compound interest daily, but advertise an APR, which may be misleading to borrowers.
With Capital One credit cards, for example, the interest is based on the daily average balance on your card for the month added to the balance each billing period. If you carry a balance from month to month, each new interest calculation is made using the new, higher base (this is APY in action).
“This is also the way investments work (compounded growth) but when the credit card company is using this principle to make money on a consumer, it's a very bad place to be for that consumer, because paying compounding interest on an ongoing basis is a very expensive proposition,” said Harvey.
The good news: “If you never carry a balance on a credit card, these rates will never be relevant because you never pay any interest. This is the best place for a consumer to be,” Harvey added.