Knowing the difference between APR and APY may not seem like a big deal on the surface, but it’s something that can save every consumer hundreds, if not thousands of dollars over the course of their lives. Chances are that you’ve heard of both of these terms but haven’t given much thought to how they are computed. Know that whether or not you are being quoted APR or APY, you are always given the number that looks better to you. We’re going to first define what each of these terms mean, then provide a real-life example of how it can affect you.
Annual Percentage Rate (APR)
APR, an acronym for “annual percentage rate,” is a common term used mostly when defining the interest that is paid on a mortgage, credit card or other loan. APR can be applied to any interest rate and it will always be equal to or smaller than APY. APR generally does not need any calculations to compute, it’s simply the rate applied to money borrowed. Lenders usually will try to apply this rate as often as possible, so if your credit card APR is 15%, they apply that percentage to your “average credit card balance” everyday, after the grace period. If you check your credit card statement, you will see that the 15% APR is divided by 365 days in the year to show your daily periodic rate of 0.041095. If you are able to pay off your entire balance after interest is applied just once, then 15% is an accurate representation of your interest rate, however if you carry a balance from month to month, then you’re paying more than you think.
Annual Percentage Yield (APY)
APY, an acronym for “annual percentage yield” is a common term used mostly when defining the interest paid in a savings, checking, or other interest bearing account. Unlike APR, APY reflects interest paid on interest, which always makes this number higher than its counterpart. Because interest is generally compounded quarterly, monthly, or daily, the interest added in your account becomes part of your average daily balance. When it comes time to calculate that number again, your balance is raised, thus causing a higher interest amount to be applied. Unless you withdraw from an interest bearing account, you can expect your interest deposits to be greater in size each time they are calculated.
APR and APY in Action
So, now that you understand the difference, let’s see how it would effect you in a real life situation. First, let’s say that you have a savings account with an interest rate of 3%. A pretty awesome interest rate these days and for purposes of the example, it’s a easy percentage to work with. So lets say you decide to make a deposit of $5,000 in this savings account. Over a 12 month period, interest would be applied to your account once a month, at a rate of 0.25% (3% interest rate divided by 12 months). If you simply took the 3% and applied it once to the balance at the end of the year, you would expect to earn a total of $150 in interest. However, because interest will be earned on interest, the actual rate is higher than 3%.
Over the course of a 12 month period, your new balances would be as follows:
- Month 1 – $5,012.50
- Month 2 – $5,025.03
- Month 3 – $5,037.59
- Month 4 – $5,050.19
- Month 5 – $5,062.81
- Month 6 – $5,075.47
- Month 7 – $5,088.16
- Month 8 – $5,110.88
- Month 9 – $5,113.63
- Month 10 – $5,126.42
- Month 11 – $5,139.23
- Month 12 – $5,152.08
You can see in the model that the actual interest owed after a 12 month period is $152.08, not the $150 the APR would lead you to believe. When interest is compounded monthly, as in this example, the actual APY of a 3% interest rate is 3.04%. The more times an interest rate is applied to a balance, the higher the APY will get. So interest compounded daily would have a higher APY then the example above, and interest compounded quarterly would have a lower APY. When interest is compounded monthly a 3% APR is equal to a 3.04% APY.
If you applied this $5,000 to a credit card balance owed, APY would become a less attractive model to use. In regard to a credit card account, you would probably have to pay off a certain amount of your bill every month, making the actual interest you would pay less than the $152.08 the example shows (assuming you didn’t charge more to the card). You will be paying off a portion of your bill with every statement, making the principal + interest amount lower each month.
APY always gives you a more accurate representation of how much money you will earn or owe at the end of a full term or year. Because home loans, auto loans, savings accounts, CD’s and other similar accounts are rolled over from month to month, interest begins to accrue and interest is earned on interest. When you shop for a savings account, for example, it’s important to compare APY. For example, the EverBank money market account currently offers a bonus rate for the first three months, then the rate lowers to EverBank’s prevailing rate. While comparing this offer to other banks would be difficult using APR, APY factors in the changes in rate and compounding. Thus, it is easy to compare EverBank’s first year APY of 1.26% (as of 6/14/11) with say Ally Bank’s first year APY of 1.04% (again, as of 6/14/11).
Finally, when it comes to mortgages, you’ll often see a quoted “rate” that is lower than the APR. The rate represents the interest rate on the loan, while the APR factors in other fees (such as points) that you’ll pay. The APR is always higher than the rate. The key is that when you compare mortgage rate quotes, make sure you are comparing an APR that has factored in the fees you’ll pay with the loan.
The upshot of all of this is simple-The next time you are looking into a loan or savings account, make sure to compare the APY.