When researching loans, credit cards, investments, and high-yield savings accounts, you’ll often come across terms like APY, APR, and interest rate.
Annual percentage rate (APR) is what you’ll see most often when banks and lenders discuss terms and conditions regarding interest. However, annual percentage yield (APY) may also be used in reference to a variety of financial products. Because the amount of money you can earn or have to pay is impacted, it’s important to understand the difference between these two terms.
Here’s an overview of what APR and APY are and how each one affects how much you pay back to a lender — or how much you earn on your money.
What is the difference between APY vs. APR?
APY — sometimes called effective annual rate (EAR) — is often discussed with savings accounts, investments, and Certificates of Deposit (CDs) as the amount of interest earned on the money you stash away. If APY is calculated in reference to loans or credit card debt, then you’re looking at the amount of interest you’re being charged.
In its simplest terms, APY is the percentage of interest accrued over the course of a year with compounding taken into account. When interest is “compounded,” the amount of interest you accrued during a given time period is added to your current balance, and that new total (original balance + interest) becomes your new interest-accruing balance. The more often compounding occurs, the more your balance grows, which can be a good or bad thing.
Compounding is a great thing when you’re earning interest in one of the best savings accounts. The more often interest is compounded, the more (and faster) your savings grows. Conversely, when compounding is applied to a loan or a credit card balance, the amount you owe is what will grow.
APR, on the other hand, calculates simple interest on an amount of money borrowed over the course of a year. It doesn’t take compounding into consideration and, therefore, doesn’t give you the fullest picture of the costs or gains involved.
Why understanding compounding matters when it comes to your money
When you compound interest, you add more to the account balance at regular intervals, such as daily, monthly, quarterly, annually, etc. The more often the bank compounds interest on your savings account, the more “free” money you earn (this is part of why high-yield savings accounts that compound daily are so powerful). And, of course, the more often interest is compounded on a loan, the more money you pay.
Let’s run some numbers on a savings account first:
- Say you put $10,000 in a high-yield savings account that pays 2% APY compounded annually. You’d earn $200 in interest in one year.
- If that high-yield savings account compounded monthly, that means you’d earn on one-twelfth of your 2% APY each month (or .167% each month). Broken down, that means:
- You’d earn $16.67 in interest your first month, which would raise your interest-earning balance to $10,016.67.
- Assuming you didn’t make any withdrawals, the interest earned in the second month would then be $16.69, and that would be “compounded” again onto the balance of $10,016.67 for a new total balance of $10,033.36 going into month three.
- If this pattern repeated throughout the year, you’d end up earning 2.01844% in actual interest (or $201.84).
So, more frequent compounding on savings plays in your favor. But check out this chart as an example of how different frequencies of compounding can have a major impact on something like a credit card interest rate:
|Rate of compounding and resulting actual interest rate|
One of the reasons you need to be aware of how APR vs. APY works is that credit card interest and loan interest is sometimes advertised with the APR and not the APY. Companies do this so that their products seem like a better deal than the reality. As in the example above, when you take the time to calculate the APY, you discover you’re actually paying more money back than what an APR suggests.
This is why it’s important to understand how interest is calculated for any loan, credit card, investment, or savings account before deciding to sign up.
How to convert APR to APY
If you want to see what the APY is on a loan or credit card that only tells you the APR, you can do so with some quick calculations. The easy way is to find an online compound interest calculator. You can input the APR and the compounding rate to find the APY percentage.
If you want to do the conversion by hand, you can use this formula: APY = 100 [(1 + r/n )n – 1].
In this equation, “r” stands for the interest rate (use the stated APR), and “n” stands for the number of times interest is compounded in a year. Let’s see how this works using one of the examples from the table above.
Your credit card has a 13.99% APR, so r = .1399
Your interest is compounded monthly, so n = 12
Plug in the numbers and calculate (if it’s been a while since high school math, remember your order of operations: PEMDAS — parentheses, exponents, multiply, divide, add, subtract).
APY=100 x [(1+.1399/12)12-1]
APY=100 x [(1+.0116583)12-1]
APY=100 x [(1.0116583)12-1]
APY= 100 x [(1.14922-1]
APY= 100 x .1492
Why it’s important to understand APY vs. APR
Understanding your money is key to both making and not losing your cash. Though it may not seem like you’re paying all that much more when you look at APY over APR, you’re still paying more money than you may have understood at the beginning of a loan.
The same is true when considering investments and the best savings accounts. Knowing just how much money you’re making and how much more even half a percent can mean may add up to significantly more in earnings.
When you’re looking at different financial products where interest is involved, make sure you compare apples to apples: APY to APY and APR to APR. Use an online calculator to figure out APY when it isn’t supplied by the lender or bank so you know exactly what to expect in earnings or expenses.
The numbers will lead you to make financial choices that place your best interests front and center.
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