What is the difference between APR and APY? Advertisements and contracts will rattle off one of the two, among a number of other acronyms, leading many to misunderstand or simply gloss right over them. The difference between APR and APY is one of the basic considerations that you need to know for handling your own finances.
Both APR and APY are pieces of information that help you understand an interest rate. APR is used primarily as a borrower’s side to understand the real cost of a debt, while APY is used on the investor side to view the yield of an investment.
Annual Percentage Rate (APR): Interest Rate & Charges
Annual percentage rates (APRs) help you understand a loan’s interest rate charge combined with all other expenses that may be part of your loan. It is a measure of the costs of your loan. APR is communicated as an annual percentage of the loan’s principal, or as a percentage of how much you borrowed.
APR is calculated as the loan’s fees and interest divided by the principal, then divided by the number of days in the loan term. Finally, this number is multiplied by 365 and then multiplied by 100 to give you the final annualized rate expressed as a percentage.
For example, if you have a loan with an APR of 10% and a principal of $1000, you’ll pay $100 in interest per year. If you pay $200 per year in payments, you’ll then only be paying $100 toward the principal while the other $100 is paying for the interest.
APR has a serious limitation in that it does not show the effect of compounding. If you try to use the APR to calculate how to pay off your credit card debts, your calculations will likely be off because the high interest rates will quickly grow the principal while you’re trying to pay it down. APR does, however, give you a realistic way to compare the costs or rates offered by various lenders.
Annual Percentage Yield (APY): Compounding Yields
By contrast, annual percentage yields (APYs) show the actual yield of an investment. The mathematical formula behind APY has compounding interest built into it. Compounding interest computes interest on the outstanding principal and on any interest not paid in the previous compounding period, generating “interest on interest.”
The formula for calculating APY is 1 plus the annual interest rate divided by the number of times that it is compounded per year. Then this total is raised to the power of the number of compounding periods per year — for example, if there are 12 compounding periods, raise the figure to the 12th power. Finally, subtract 1 from the result to get the yield expressed as an annual percentage.
If you use the APR and APY formulae on the same instance, they will give you slightly different rates unless the interest rates are compounded annually for the first year. If it is compounded over multiple years, APY will end up being larger than APR. In turn, the more frequently the interest is compounded, the more the APY rate will grow relative to the APR.
This is because the APR is, functionally, showing you the periodic rate, which may or may not be the same as the annual interest rate. The periodic rate is the annual rate of interest divided by the number of periods. So if your annual interest rate is 12%, the monthly interest rate is 1%. Whether that 1% interest each month is compounding upon itself throughout the year — or not — changes the effective annual rate shown by the APY formula.
In general, many financial products are better understood over a long term using the effective APY rather than the APR. This is especially important when borrowing money because APR and APY can result in very different effective rates, which can obscure what you’re actually paying in interest.
The Big Picture of APR and APY
APR and APY each have their uses. APR gives you a good idea what your monthly payments will be, helping you to understand what the impact of a loan will be on your cash flow. APY, by contrast, helps you understand the longer-term yields on your investments or total costs of your debts, better allowing you to understand these things at a strategic level.
Broadly speaking, APR works well as a tactical view, while APY gives you that higher-level view.
What to Watch For
Comparing APY with APR will leave you with a false comparison. When shopping for the best rates, make sure to compare apples to apples.
Financial institutions — whether they are local credit unions or companies selling complex financial products — tend to include these two rates along with other terms like “current rates” and “effective rates” to make comparing unlike products more difficult. This is a common sales tactic aimed at hindering your understanding of how quickly interest accrues in your favour or how fast debt or costs will compound against you.
Banks and credit card companies often use APR to advertise debt and loan options in order to obfuscate the realities of compounding interest rates on your balance. By contrast, nearly every savings or investment option will advertise its APY to reinforce the importance of the interest or returns compounding for you.
APR and APY are both effective ways of portraying interest rates and can be effective tools in understanding the financial products you use. Be aware that those who are seeking to sell you something may try to use one or the other of these figures to give you a good story, and not necessarily paint the most accurate picture of how your costs or interest will grow over the long term.
Like everything else in life, these are tools that can be used effectively if you use them intelligently.