You’ve no doubt heard of both of the terms, APR and APY. Most people, however, haven’t given much thought to how they are computed. Creditors will quote interest rates using either APR or APY. They almost always quote the number that looks better to you. Thus, it is important to know the difference.
We’re going to first define what each of these terms means. Then we’ll provide a real-life example of how it can affect you.
Table of Contents:
Annual Percentage Rate (APR)
APR is an acronym for Annual Percentage Rate. The term is mostly used when defining the interest that is paid on a mortgage, credit card or other loan. You can apply APR 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 apply this rate as often as possible. For example, if your credit card APR is 15%, they apply that percentage to your “average credit card balance” every day, after the grace period.
The credit card company divides the 15% APR by 365 days in the year. The result is a daily periodic rate of 0.041095. If you pay off your balance after interest is applied once, then 15% is an accurate representation of your interest rate. If you carry a balance from month to month, however, then you’re paying more than you think.
Annual Percentage Yield (APY)
APY is an acronym for Annual Percentage Yield. It is a common term used when defining the interest paid in a savings, checking, or other interest bearing account. Unlike APR, APY reflects interest paid on interest. Thus, APY is always higher than APR. Interest is generally compounded quarterly, monthly, or daily. As a result, the interest added to your account becomes part of your average daily balance.
The balance increases when interest is applied. Since your balance is now higher, more interest will accrue the following month. The amount of interest you earn will grow each month, unless you withdraw from the account.
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APR and APY in Action
So, now that you understand the difference, let’s see how it would affect 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. For purposes of the example, it’s an easy percentage to work with. So let’s say you decide to make a deposit of $5,000 in this savings account.
Over a 12 month period, the bank would credit interest 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, the actual rate is higher than 3% because interest is earned on interest.
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. This is of course more than the $150 the APR would lead you to believe. When we compound interest 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. So interest compounded daily would have a higher APY then the example above, and interest compounded quarterly would have a lower 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.
Why APY is Valuable
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. Home loans, auto loans, savings accounts, CD’s and other similar accounts roll over from month to month. Therefore, interest accrues on interest. When you shop for a savings account, for example, it’s important to compare APY.
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.