APR Vs. APY: Definitions And Key Differences
Sarah Li Cain4-minute read
August 01, 2022
Interest rates can have a big impact on your finances. Understanding the difference between an APR and an APY is especially critical. Although just one letter apart, these two terms have wildly different impacts on your finances.
Let’s take a closer look at APY vs. APR to see why these terms matter so much.
What Are APR And APY?
Both terms sound similar. Before looking at how they’re applied to interest rates, let's take a look at what these terms mean and their usage.
Annual Percentage Rate (APR)
Annual percentage rate, or APR, is a term used to describe the interest rate that’s charged to the borrower or paid out to an investor. You’ll typically see it as a percentage, representing the annual cost over the term of your loan.
The APR also includes any additional costs or fees associated with your loan or investment. As in, it calculates the percentage of the principal paid annually by looking at factors such as monthly payments. But it doesn’t take compounding interest into account within a specific year.
Products that tend to utilize APR include:
The APR is a useful number since you can easily use it to compare rates with other lenders.
Annual Percentage Yield (APY)
Annual percentage yield, or APY, also refers to the amount of money or interest earned (or paid if it’s a loan) on an annual basis after factoring in compound interest (more on this below). You’ll generally see APY advertised for both investment products and deposit accounts.
These types of accounts include:
- Certificates of deposit
- Checking and savings accounts
- Money market accounts
When you open an investment or deposit account, banks or credit unions typically use your deposits to issue loans to other customers. As an incentive, financial institutions offer money – specifically an APY deposited into your account – to consumers with open accounts.
What’s The Difference Between APR And APY?
When looking at APR vs. APY, a big difference is whether you will pay interest or earn interest. Typically, APRs are used to show borrowers how much the loan will cost. But APYs show savers and investors how much they can earn through the account.
The other key difference to note is how compound interest is considered for APY vs. APR. Here’s a closer look at how compound interest impacts these metrics.
How Compound Interest Affects APR Vs. APY
Both terms refer to interest rates but a major difference between APR and APY is whether it takes into account compound interest (spoiler alert: APY does, but APR doesn’t). APR only calculates simple interest – you multiply the daily interest rate by the number of days between payments.
APY is the amount of interest earned after taking compound interest into account – interest earned on the principal amount in addition to the interest you’ve already accumulated.
When researching financial products, you’ll notice that different ones tend to market either the APR or APY. That’s because it encourages consumers to open accounts by making an interest rate look higher or lower.
For example, lenders typically show you the interest you’ll pay in APR because it looks as though you’re not being charged as much. Compare this to investment products where APY tends to be advertised because it looks like you’ll earn more in interest.
While neither method is right or wrong, it’s important for you to make accurate comparisons before biting the bullet on any products. To do so, compare the same types of rates – whether that’s APR or APY.
How Do You Calculate APR Vs. APY?
Breaking down how APR and APY are calculated can help you better understand how each metric takes interest into account. It’s time to do some math!
You can calculate the APR by multiplying the period interest rate by the number of days in the loan term:
APR = ([fees & interest paid over lifetime of loan ÷ principal loan amount] ÷ number of days in your loan term) x 365 x 100
Let’s say you take out a personal loan for $15,000. You are paying a 12% interest rate, compounded annually, over the life of the loan with a $600 closing fee for 5 years (or 1,825 days). With a monthly payment of $333.67, here’s how the calculation works:
(([$600 + $5,020] ÷ $15,000) ÷ 1,825) x 365 x 100 = 7.49%
That means your true APR is 7.49%.
Remember, you’re paying less in interest and more toward your principal as you progress through your loan term.
Remember, calculating APY needs to take into account compound interest so the formula may look a bit more complex:
APY = (1 + (interest rate / n))n - 1
Here, n equals the number of compounding periods in a year (12 for monthly, 365 for daily).
For example, you open a savings account and deposit $10,000 with an interest rate of 1.5%.
Here’s how you calculate the APY if interest is compounded monthly:
(1 + (0.015/ 12))12 – 1 = 1.51%
This means your interest rate is effectively 1.51%.
Considerations When Comparing APY And APR
APRs and APYs have a big impact on your loan products and investments. As you compare APYs and APRs, make sure to keep these tips in mind.
- Compare the same type of interest rate. It’s critical to compare apples to apples. If you start comparing APRs to APYs, you won’t be able to accurately compare the merits of a particular financial product.
- Determine how often interest is compounded. The compounded interest has a big impact on your savings. More frequently compounded interest is in favor of the saver. But frequently compounding interest isn’t a good thing when it comes to loan products.
- Consider how APRs and APYs vary between accounts and products. The APR or APY you can expect varies significantly based on the financial product. For example, the APRs for a cash advance are often much higher than the APR on regular credit card spending. Additionally, high-yield savings accounts are known for offering much higher APYs than a traditional savings account.
The Bottom Line
When shopping for loan products or investment opportunities, it’s good to know how APR and APY work. When taking out a mortgage, you’ll want to compare APRs to find the best rate. Ready to dive into homeownership? Get approved for a mortgage with our team today.
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