Banking 101: What is the difference between APR and APY?
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 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.
No, it's simple mathematical fact. People can get by with addition. subtraction, multiplication and division...all taught in elementary school. Interest computations require multiplication and addition. If that's too confusing, hire an accountant.
CD #1 9 month 5% APY
CD #2 12 month 4% APY
Which CD has the higher interest rate? Answer CD #1
It was the APY that allowed me to compare the 2 terms on equal footing.
The issue is not compound interest, it is the interest and the time perioed!
Forget your calculators, show me the real money received at 6 mo.
For terms less than one year, add the principal and the interest received, multiply by the months of the CD and divide it by 12 (that is your APY), see how simple it is, APY will always be wrong on your above APY assumption.
1. Always compare investments of different term lengths by APY.
2. All investments have a 'correct' APY. Math is shown in the article above.
3. Yes, the 'rate' at which money is earned at 6 months is slightly less than APY. But do use APY if you're planning to reinvest the money. (A 1 year CD with the same APY will have earned exactly the same if you compare after 6 months!)
Another question, if the calculation do apply to one month CD, how is the APY calculated and why. I'm trying to help you understand the differences in calculations. Another hint, the APY is recalculation of the newly added interest and is exponential accounting, which means most of the interest on the interest is earned at the end of the CD period and not upfront. I hope you will understand that and close this case.
1. 6 month 3% APY
2. 17 month 3.1% APY
3. 9 month 3.25% APY
Which CD has the best rate? Answer #3. See no calculation required and that is the point so you can compare apples to apples. Now if you did the calculation the 17 month CD would earn more actual dollars but my money would be in the 9 month CD getting a better rate. Then I would re-deploy those funds again after the CD matures. It's not rocket science.
Your assumption that you could profitably redeploy money at the end of the 9-month CD is uncertain. If rates drop past a certain point the guy with the 17-month 3.1% CD will beat your pants off.
AGAIN the "A" in APY stand for annual or 12 compounds of interest credited, see, nothing to be confused about.
In fact, APRs can be more confusing, because what you receive at the end depends on the compounding method. Daily? Monthly? Continuous? These would all be different APRs for the same amount of money you'd receive at maturity. The only thing they'd have in common is the APY.
7 MONTH SHARE CERTIFICATE
Last Dividend Earned:
Previous Year Dividend Earned:
YTD Dividend Earned:
7 MONTH SHARE CERTIFICATE
NASA always asked for $5k new money but went to $10k.
I am not expecting a 5% deal but maybe something relatively competitive for the time period they want.
The reason I think its at least possible is they did not have to open up that 5% deal to everyone. That suggested they wanted deposits and new members. Hard to believe they will want all that money quickly removed.
Two things that make me wonder whether they'll be able to come up with something competitive (although almost certainly not 5%), are -
1) 7 months is an odd term, which maybe hints at a "special project" kind of thing, not so much a general collection of funds to allow them to make a large number of smaller loans for the next "x" number of years, and,
2) Someone in that Keesler thread actually said they'd talked to a Keesler CSR who said the funding was for "some kind of project they were doing in Jackson, Miss.". That project may or may not have a Phase 2, Phase 3, etc.
Plus, remember what the interest rate environment expectations were back in August. Let's just say they were "different".
What else do you have in mind?
If Keesler or some FI where I already have an account does not come up with something good, I guess I am willing to park it in my 2.50% checking at Northern for up to a month.
But, I feel sure that something will come up within the next 2 months.
If not, I might just invest a good chunk in stocks. I feel I have been underinvested for well over a decade given my age & risk tolerance.
Maybe one of us should try to get a big wig on the phone at Keesler? Or at least the Jackson branch manager.
If Keesler offers only poor choices, I have a "rate-insurance" add-on CD at Navy, but it caps out at only 50K (and I know they have membership restrictions). I've been actively looking for other add-on CDs with higher caps, but they're rare. There's that Mountain America one but it's capped at 100K. Also maybe NASA, though I would have to join, etc.
Yes, there's Northern (by the way, their higher rate of 2.5% is also guaranteed through June, just as the lower rate was). Then there's that Susquehanna "CD-like" liquid account at 3%, 6 months.
Dunno. Frankly, I wouldn't mind seeing a good fast market decline now. It might provide clarity, a buying opportunity, and make my choices easier! (LOL)
Use APY and just forget APR entirely. It's YIELD that matters.
Accrue does not mean paid. If you're exiting a CD before maturity you may not see the accrued interest when you cash-out. Check with the bank.
CD's are usually buy/hold instruments. Why all the angst?
Go fishing, sailing, skiing, or take a nap.
360/365 apply primarily to bank loans but it's fun to understand.
And let's not forget the leap year problem when we have 366 days!
How many days in a year?
Human says 365, programmer says 365.25 unless it happens to be a leap year in which the answer is 366 because we have to get rid of those accumulated 1/4 days somehow!
Stick to APY and leave the programming to the programmers.
I understand where you're coming from with APY. And I agree that when choosing a CD you use APY in order to make apples-to-apples comparisons between competing CDs.
However, do not be too quick to advise ignoring APR in other circumstances. For example, when checking whether or not I have been paid the right amount of interest I very often must find, and use, the APR number for the account I'm checking. APR does have relevance and usefulness, but of course not for bank-to-bank account comparisons.
On a personal note, years ago (pre-internet) back in my bond days I needed constantly to know the YTM (yield to maturity), or sometimes the YTC (yield to call), of the individual bonds I was considering buying. Sometimes I had to calculate these numbers for myself, and quickly. I also needed to be able to check for accuracy the YTM and YTC numbers being provided me by brokers, such calculations being more complex than those related to CD interest. Thank goodness for Texas Instruments and their BA-II Plus calculator. Mine never let me down. I still have my BA-II Plus and it still works, though I no longer have any use for it. :-)
1. What return do you get from your savings account after 6 months?
2. What return do you get when you break a no-penalty CD after 6 months?
3. What is your account balance on your 1-year CD, 6 months after account opening?
Right. Exactly the same as the 6 month CD with the same APY.
Nothing magical about the term length. Of course, you could argue that you have reinvestment risk. But with any fixed income investment, you ALWAYS have reinvestment risk. Let's look at a 2-year CD with 3% APY, for example. Is there a risk that your return over 5 years might be lower than 3%? Of course! Does it mean that the 2-year CD has an 'incorrect APY'? Of course not! It's your responsibility to understand the term length of your investment choices.