"APR" and "APY" are two methods used to compare financial products.
One measures how much interest you'll pay (on a loan, for example), and the other measures how much interest you'll earn (on money you've deposited in a savings account, let's say).
Knowing what APR and APY are - and learning how to use them - can help you sift through different financial options quickly and confidently. Once you grasp the concept, you'll be able to determine which product offers the best rate of interest among comparable rates:
- APR can help you find the best deal on a credit card or personal loan
- APY can help you choose the savings account or CD that maximizes the interest you earn
What is APR?
Measuring what you pay
"APR" stands for "annual percentage rate." It is used to measure the cost of borrowing, so it is applied to products like mortgages, car loans, personal loans and credit cards.
What is the difference between APR and interest rate?
Because APR has a % sign after it, people often assume it's the same as an interest rate.
But it's not.
While they are related, they measure different things.
The interest rate is a percentage that gets added to the principal of your loan, increasing the amount you owe over time. However, interest is not the only thing you pay when you borrow money. Loans may have closing costs and other fees that increase the cost of borrowing too.
To get a more accurate picture of the total costs of borrowing money, then, you need a way to measure both the interest and any extra charges together.
APR does that.
How does APR work?
APR measures the interest rate charged on your loan plus certain fees and closing costs.
By converting those fees and closing costs to a percentage and adding them to the interest rate, APR gives an apples-to-apples way to compare the total cost of borrowing.
For one-time charges like closing costs, APR spreads the impact of those costs out over the repayment term of the loan. Thus each dollar of closing costs will have a greater impact on APR for a short loan than for a long one, because the closing costs are spread out over a smaller number of periods.
Note that, while APR is helpful in including certain borrowing costs in addition to interest, it does not include all such costs. It also does not include the impact of compounding.
The Importance of Compound Interest
One key difference between APR and APY is that APR does not include the impact of compound interest, but APY does.
What is compound interest?
Simply put, compound interest measures the effect of interest earned in one time period on interest from other periods. Essentially, it's interest on interest.
Compound Interest Example:
Suppose you earn 10% on $100 in Year 1. That would leave you with $110, an increase of $10 at the end of the year.
In Year 2, you again earn 10%. However, this time you start out with $110 because of the interest earned in Year 1.
That 10% on $110 in Year 2 would leave you with $121, an increase in of $11 in Year 2.
Even though the rate of increase was the same, the difference is that, in Year 2, you earned 10% not just on your original $100, but also on the $10 earned in Year 1.
The growing impact of interest earned on interest is known as compound interest.
The above example applied interest on interest each year. Now suppose you started applying it more frequently - monthly, or even daily.
The more often you apply interest on interest, the greater the impact of compounding. So, at the same interest rate, something that compounds daily will generate more interest than something that compounds monthly.
Compounding works in your favor when you are earning interest on deposit accounts, but it works against you when you are being charged interest on borrowed money. That's important to remember as you look at the different ways APR and APY account for compound interest.
What is APY?
Measuring What You Earn
"APY" stands for "annual percentage yield." It is used to measure the interest earned on deposit products like savings accounts, money market accounts and CDs.
What is the difference between APY and interest rate?
The entire difference between APY and interest rate is the impact of compounding. Since compounding affects the actual amount of money your account will earn, this is an important difference.
How does APY work?
APY measures the amount of interest your deposit would earn over the course of a year as a percentage of your deposit. It does this based on the interest rate and on how often your interest is compounded.
For example, take two accounts with the same interest rate. Suppose one is compounded annually (once a year) and the other is compounded monthly.
The one that is only compounded once a year will have no opportunity to earn interest on interest over the course of the year. The one that is compounded monthly will start earning interest on interest after the first month. In each month after that, all the prior months' worth of interest will also be earning interest.
This ability to earn interest on interest increases the amount of money your account will earn. Therefore, the more often an account is compounded, the more it will earn.
The difference compounding can make:
The graph below shows the amount earned on $100,000 in three accounts, all at a 5% interest rate. The difference is that the first account is compounded annually, the second one monthly and the third one daily.
APY would take into account those dollar differences as a percentage of your deposit.
A fairly large deposit amount was used for this example to better illustrate the difference compounding can make. On small amounts over short periods of time the difference is generally tiny. It becomes more significant for larger amounts and over longer periods of time.
How to Use APR
You should use APR when comparing loan offers. It can help put things expressed in different terms on an equal footing.
For example, you may see one personal loan offered at 5% with a $1,000 origination fee. Another may be offered at 4.9% with a $2,000 origination fee.
APR would put both the interest rate and the fee into percentage terms so you could tell which is a better deal.
The answer would depend on the length of the loan, so an APR comparison is most valid between loans of the same length.
As helpful as APR is, keep in mind when you use it that it doesn't include everything. So, there are a couple of other things you should ask before making a decision:
- How often are interest charges compounded? The more often the compounding, the more it will cost you.
- What charges are not included in the APR? If certain fees are not included, you should take them into account when comparing loan offers.
How to Use APY
APY is pretty straightforward since it already includes compounding.
When shopping for deposit products like savings accounts, money market accounts or CDs, the APY of each product is generally advertised. All other things being equal, the higher the APY, the more interest you will earn.
When comparing APYs for CDs, you should make head-to-head comparisons of CDs of the same length. Certificates of deposit with longer terms will generally have higher APYs than CDs with shorter terms, but the trade-off is that you will have to commit to that rate for a longer period of time.
APY is a great yardstick when comparing deposit products, but it may not tell the whole story. Other factors to consider include:
- Sign-on bonuses
Sometimes banks offer new customers a one-time bonus for starting an account. Over time, these are usually relatively minor compared to the interest earned, especially on larger accounts. However, they are good to use as tie-breakers between accounts with similar APYs.
Most savings accounts do not charge monthly service fees, but some have started to. Check for these fees before signing up, and figure out the extent to which they would subtract from the interest you earn.
- Early withdrawal fees on CDs
If two CDs of the same length offer the same APY, the early withdrawal fee can be a great tie-breaker. Choosing the one with the lower early withdrawal fee could save you some money just in case you need to get out of the CD early.
When looking at financial products, don't be put off by jargon like "APR" and "APY." Instead, try to learn about them and incorporate them into your financial planning activities. These are useful measurement tools for comparing products that can help you make good choices.
Knowing the strengths of APR and APY - and their limitations - can put extra money in your pocket when dealing with loans or deposit accounts.