You'll see these the abbreviations "APR" and "APY" in connection with financial products that involve interest. This can include deposit products such as savings accounts and certificates of deposit (CDs) where you earn interest, as well as loan products such as mortgages, where you pay interest.
APR and APY look so similar that people may assume they can be used interchangeably. Because they are usually followed by a percentage amount, you might think that they mean the interest rate. However, while all these concepts are closely related, there are subtle differences. Those differences add up to dollars, so consumers are wise to understand them.
Definitions for APR and APY
A good place to start is by defining the key terms, because this makes it easier to understand the significance of the differences between them.
What is APR?
Annual percentage rate, (APR) looks at the concept of paying for the use of money comprehensively. In addition to the interest being charged on a loan, it takes into account other money you are paying to the lender, such as fees and points.
An interest rate is the percentage paid on a money balance for temporary use of that money. When you give a bank use of your money by opening a deposit account with them, they pay you interest. When a bank or other lender gives you the use of their money by making a loan, you pay them interest.
The difference between an interest rate and an APR doesn't come into play much with deposit accounts, but it is vital to understand for borrowers. Lenders often offer a lower interest rate in exchange for higher fees or points being paid. APR is a key figure to use when comparing loan offers.
What is APY?
Annual percentage yield, APY, is an important concept for both loans and deposit accounts.
On a deposit account, APY captures not just the interest rate but the impact of compounding. That impact depends on how frequently the interest in your account is credited. This matters because once interest is credited to an account, you can start earning interest on that interest. So, the more frequently interest is credited, the higher the APY should be.
For example, consider a $100,000 savings account balance with a 5 percent APR. If interest at that rate is credited to the account just once, at the end of the year, the account would earn $5,000 in interest the first year. If, however, that 5 percent APR is broken into 365 daily increments and that interest is credited daily, the account would accumulate interest sooner and thus be able to earn interest on interest previously earned from the second day onward, totaling $5,126.75 over the course of the year, if no funds are withdrawn.
More frequent compounding means a bigger difference between APY and APR. This translates to earning more money when you have a deposit account, or paying more when you are borrowing money. Either way, it is worth knowing how frequently interest is compounded and the resulting difference between APY and APR.
When does compounding matter most?
It's easy to overlook the effect of compounding in an era when the average savings account is paying just 0.06 percent interest. At that rate of interest, daily compounding means the difference between APY and APR is just 0.000018 percent, or the equivalent of $1.80 in annual interest on a $100,000 account.
A 5 percent APR daily compounding would create a 0.12675 percent difference between APY and APR, worth $126.75 on a $100,000 account. At 10 percent APR, daily compounding would boost the APY to 10.5156 percent, worth an extra $515.60 on a $100,000 account.
The takeaway here is that the difference between APY and APR gets steadily greater at higher interest rates and the larger the sum of money involved. Be sure to ask about that difference to see how much it matters in your situation.