Key financial terms like APY and APR can be confusing to interpret. You’ve most likely seen these acronyms when opening a bank account or reviewing current accounts. While APY and APR may sound similar, they are actually two distinct concepts. APY stands for “annual percentage yield,” while APR stands for “annual percentage rate.” APR refers to your yearly rate without taking compound interest into account, while APY includes how often interest is applied to your balance.
- The Difference Between APR and APY
- How To Calculate APR and APY
- APR vs. APY: What Is Compounding?
- Comparing the Same Rates
To break it down, APY is the interest you earn on money stored in a savings account, while APR is the interest you owe when you borrow from the bank. It’s important to know the difference between these two key terms as they impact your finances, especially when investing or taking out a loan. APY and APR affect how your interest is ultimately calculated. Knowing the difference between APR vs. APY could help you earn more or owe less money.
APR is the total interest paid on a loan over one year, whether that be a credit card or an auto loan. While the annual percentage rate is largely based on the interest rate, there are some loans that also calculate account points, fees accrued and other costs associated with taking out a loan. More importantly, it does not take compound interest into account. This means the consumer does not know how often the bank will compound the interest you’re accruing.
Many factors go into calculating APR. It’s important to look at credit card APRs specifically, as there are often different rates for different transactions. For example, there could be a separate APR for regular purchases and cash advances. APRs for mortgage loans may include things like insurance and closing costs. Read the fine print when looking at APR, and ask the bank what is included in the APR being offered. The higher the APR, the more interest you will pay over the course of that year.
Related: What Is APR?
APY is the total amount of interest you earn on a deposit account over one year. Unlike APR, annual percentage yield factors in compounding interest. Banks are required to display their APYs for each of their accounts, which can be compounded daily, monthly or annually.
The interest earned here is basically the bank paying you for lending them money. You can accumulate money faster when you are earning interest on your interest. APYs are mostly associated with savings accounts, money market accounts and certificates of deposit (CDs). But understanding how compounding interest works is essential when it comes to annual percentage yield.
Just as APR and APY mean different things, they are both calculated differently. Remember, the higher the APR, the more interest you pay. The higher the APY, the more interest you are earning.
The type of credit issued to the consumer determines how APR is calculated. If your loan has a single repayment, you can calculate it in the following steps:
- Take the cost of the loan in interest and finance charges and divide it by the amount borrowed or current balance.
- Multiply that number by 365.
- Divide the sum by the term of the loan in days.
Example: A $1,000 payday loan with $50 in fees for 14 days:
- $50 ÷ $1,000 = 0.05
- Then 0.05 x 365 = 18.25
- Then 18.25 ÷ 14 = 1.30% APR
You can certainly calculate APY on your own, but many financial institutions have APY product-specific calculators embedded on their websites for consumers to use. However, you can calculate APY by using this formula:
APY = (1 + r/n)n – 1
The “r” in this equation is the interest rate, and the “n” is the number of compounding periods per year. APYs may look incredibly small, but these small percentages can quickly add up. Make sure to compare APYs across accounts and banks to determine the best potential earnings.
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Compounding interest is additional interest to the sum of your loan or deposit. Basically, it’s interest on interest. Compound interest can be positive or negative, which depends on if you are earning the interest or paying it. Be aware that APR only shows the annual interest on an account without factoring in compounding interest.
It’s also important to understand how often the interest is compounded. For example, imagine your initial investment is $10,000 with an interest rate of 1.70%. The length of time for this investment is three years, which is compounded monthly. Based on this compounded interest, in one year, you will have $10,171.33. In three years, you will have $10,522.85. While this isn’t a considerable amount, one can imagine how much money you can make over time.
When comparing the same types of rates for certain accounts, always make sure you are comparing apples to apples. Focus on the APY to APY or the APR to APR to get an accurate representation of which account may be best for you.
Online banks typically have more attractive APYs, as they have lower overhead costs. They also tend to have lower maintenance fees and minimum balance requirements, which is often more attractive than the typical brick-and-mortar bank.
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