APR vs APY: What's the Difference?
You might have heard the terms APR and APY when looking at investments, loans, or credit. But do you really understand the difference between the two?
It’s important to understand the difference between APR and APY because they can significantly affect how much you earn on your investments or how much you pay in interest. APR measures the amount of interest charged while APY measures the amount of interest earned.
Basically, APR (Annual Percentage Rate) uses simple interest, while APY (Annual Percentage Yield) uses compound interest. What’s the difference between simple and compound interest?
Simple vs. compound interest
In rough terms, simple interest is calculated by applying an interest rate only to the principal (original) balance of a deposit or a loan.
Compound interest applies an interest rate to that principal balance and also to any accrued interest for a given period. In other words, compound interest is calculated based on both the original balance and the interest earned by that balance over a given period.
The Office of Financial Readiness has more information about the difference between simple and compound interest.
As we said above, APR does not take into account compound interest during a specific year. Instead, APR is calculated by using a simple interest formula, that looks like this:
APR = Rate x Number of Periods in a Year
It’s a fairly simple formula, but what does it actually look like in the real world? Let’s say a credit card company charges 1% interest each month. The APR for that card would then be 12% based on the formula:
APR = 1% x 12 months = `12%
Unlike APR, APY does take into account the compounding interest within a given year. This is also called intra-year compounding. As you might imagine, the formula for calculating APY is a little more complicated than calculating APR.
APY is calculated by adding 1 to the periodic rate (as a decimal), then multiplying by the number of times the rate is applied, then subtracting 1.
The formula for APY looks like this:
APY = (1 + Periodic Rate)Number of Periods – 1
Using the same hypothetical scenario we used for APR, a real-world example might look like this:
APY = (1 + 0.01)12 – 1 = 12.68%
At its basic level, compound interest means earning or paying interest on previous interest added to the principal balance of a deposit or loan.
Make sure you’re informed
When you’re shopping around for any type of loan, say a mortgage, your lender may give you a low quote. However, this could just be the APR on the loan. It might not take into account any intra-year compounding.
Remember too, compound interest can be applied semi-annually, quarterly, or even monthly. So make sure you fully understand the interest rate and how it’s actually applied to the loan.
Understanding the difference between APR vs APY is important for managing your personal finances. Because of how each one is applied to a loan or investment, you could end up either paying more or earning less if you get the wrong rate.
Want to learn more about managing your personal finances? We have a lot of helpful articles here in our Learning Center to help put you on the right track.