If you’re looking at any kind of savings, investment, loan, or credit card account, you are likely to see the terms APR and APY. APR is an abbreviation for annual percentage rate. APY is short for annual percentage yield. While APR and APY are similar in several ways, a critical difference has a huge impact on your finances. Keep reading to learn more about APR vs. APY and how they influence your money.
What Is APR?
Annual Percentage Rate (APR) is a method of measuring borrowing costs for loan accounts. Credit cards, auto loans, personal loans, student loans, home mortgage loans, and lines of credit are required by law to include an APR, so you understand what you’re paying for every dollar you borrow.
APR combines the loan’s interest rate and other fees. For example, a mortgage loan APR includes points, fees, and additional charges, not just interest. APR helps you more easily compare loans and know which is least expensive.
To calculate APR, lenders do the math to figure out what you would pay for a loan if all of the charges were included in the interest rate instead of broken out as fees. Using APR, you can quickly make an apples-to-apples comparison.
What Is APY?
Annual Percentage Yield (APY) is a standard method of measuring interest rates for savings accounts and other products where you earn interest. Federal regulations for account disclosures and advertising state that APY should be calculated showing the amount of interest you would earn over a year or another specified period.
Because savings accounts, certificates of deposit (CDs), and money market savings accounts may pay interest on different schedules, APY gives you a simple method to compare accounts and quickly estimate what you would earn from keeping your funds in an account over the next year.
A higher APY is best for your financial results for savings and investments.
What Is The Difference Between APR And APY?
There are a few significant differences to consider when looking at APR vs. APY. First is how they are most commonly used. The second is the math that goes into calculating APR and APY.
As noted above, APR is mainly used when borrowing, while APY is mostly used when saving or investing. APR tells you how much money you’re spending to borrow money. APY explains how much you can earn from your savings or investments. You can calculate APR as a percentage of the initial amount borrowed. APY is a percentage of the initial savings or investment.
If you dig into the formulas, there is a major difference in how APR and APY are calculated. APR chips away at a borrowed balance over time, while APY includes compound interest you can earn.
The Major Difference: Compound Interest
While he likely didn’t actually say it, there’s a famous quote attributed to Albert Einstein regarding the power of compound interest. “Compound interest is the eighth wonder of the world,” the saying goes, “He who understands it, earns it; he who doesn’t pays it.”
While it isn’t included in APR, APY factors in compound interest. Compound interest is the money you earn from the interest you already earned.
For example, let’s say you have a bank account that pays interest every month, called compounding monthly. If you save $100 in the account and earn $1 at the end of the month, the next month, your interest is calculated based on having $101, not just the original $100. Over time, the interest you earn through compounding can add up.
How To Calculate APR and APY
Here is the formula used to calculate APY, though it may be easiest to use a premade APY calculator on the web.
When calculating APR, follow this formula:
What is better APR or APY?
There is no better or worse option when looking at APR vs. APY. APR is best used for specific financial tasks, and APY is best for others. APR is used for borrowing and debt. APY is used for savings and investments.
With a complete understanding of APR and APY, you can make the most informed financial decisions. If you’re shopping around for a home loan or a mortgage, a slight difference in APR could lead to massive savings over time. And when saving, a more favorable APY means you have more money in the bank. That’s something anyone would appreciate when looking to level up their finances.