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APY, annual percentage yield, and APR, annual percentage rate, may seem interchangeable, but they are not.
Don’t worry. You’re in the same boat as most if you think the two are the same. Until you do a little bit of research and really throw yourself into making important and appropriate financial decisions, you won’t know the main difference between an APY and APR.
APY vs. APR Overview
The two interest accruing rates do have one thing in common: They both affect how much money you earn on an account or how much money you’re responsible for paying through a loan. The difference between the two is that APY includes compounded interest and APR does not.
To go into a bit more detail, APR associates itself with your yearly interest percentage rate – also known as the simple interest plus the fees. APY associates itself with your yearly interest percentage rate, but it also includes weekly, monthly, quarterly, or yearly compounding, therefore earning you more than a traditional APR.
If you have an APY on one of your investments, the compounding periods will give you more money to your principal balance. That’s why most people prefer an APY over an APR if applicable.
Annual percentage yield is commonly found as an option if you open a deposit account or purchase an investment product.
Examples include a savings account, a money market account, or a certificate of deposit. You opening one of these accounts gives the banking institution or credit union the ability to fund loans for their other prospective customers within the branch.
Because you’re doing your banking institution or credit union such a “solid,” they want to help you out, give you a reward.
To incentivize, the branch will offer you interest on the money you deposit into your selected account – and compound it either weekly, monthly, quarterly, or yearly. With this setup, you’re able to earn interest on both the principal amount you have in the account and the interest that’s already accumulated thus far.
Annual percentage rate is most commonly referred to as the interest that the borrower pays yearly on a loan. Typically, the APR correlates back to a mortgage, car, or credit card payment.
APR is very different from APY, as previously stated. It’s also much different than regular simple interest, as APR has several additional fees on top of the initial interest rate. That’s why when you’re comparing interest rates and APRs, the percentages don’t always line up and often differ.
APR vs. APY Calculation
APR and APY calculations differ.
Many financial institutions use APR as an advertisement promotion to show you that you’ll end up paying less money on your loan, mortgage, or credit card if you sign up with their specific branch. But what they don’t consider is the compounding annual interest rate – this number doesn’t apply to APR.
All in all, APR then calculates itself by multiplying the periodic rate by the periods per year in which the periodic rate is applied. Institutions do leave out that the APR does not specify the number of times this rate is applied to the balance. See the formula below.
On the other hand, many investment companies use APY to advertise to get investors to purchase CDs, IRAs, and savings accounts.
Unlike APR, APY does consider compounding interest, meaning you will earn more overtime on your chosen account. Even if the earnings are not extremely high, you’re still getting more back than you would with a simple interest rate.
APY calculates itself by adding 1+ whatever the periodic rate is in decimal form. Once you have that number, start by multiplying it by the number of times the compounding will happen annually and then subtracting one. See the formula below for a better visual representation.
To calculate your accurate APY, use this formula:
APY = (1 + Periodic Rate)Number of periods – 1
To calculate APR, use this formula:
APR = Periodic Rate x Number of Periods in a Year
>> More: How Interest Rates Work
What Is the Difference Between APR and APY?
APY and APR are two extremely important and different terms to consider and understand when researching interest rates.
You see, APY aims to show you that your chosen account can earn a high sum of money over time. Whereas APR has a very different goal: To make it seem like the cost of borrowing is low enough for you to afford long term. But in the end, both APY and APR want to make their interest percentages as attractive to you as possible so that you pick their offer over other financial institution offers.
What Is Better APY or APR?
In my observations, I would never say that one is better than the other, as they’re both entirely different. APY primarily concerns interest earned, and APR concerns itself with interest owed, so saying one is better than the other would be illogical.
One thing to note is that both APY and APR claim they represent the money owed on or money earned in an account – but some of the fees are often not spoken of.
Bottom Line: APY vs. APR
At the end of the day, both APY and APR are very important concepts in the finance world. APY regulates the area of finance dedicated to saving, and APR regulates the area of finance dedicated to paying.
If you’re signing up for a credit card, looking for a manageable loan, or seeking a savings account with a high rate of return on your deposits, it’s crucial to know what percentage rate you’re dealing with. Educating yourself on the differences is just the beginning of wise financial decisions.
My advice? Go to a variety of financial institutions and ask their officials what the APY or APR rates are like. Compare and contrast between branches and choose the one that best fits your current financial needs.