Hannah Logan
Clay Jarvis
When comparing financial products online, we often see percentage rates next to acronyms like “APR” and “APY”.
Even though these terms are different ways of referencing an interest rate, they differ substantially Whether you’re borrowing money or stashing it at a bank, it’s important to understand what these differences are.
- What is APR (Annual Percentage Rate)?
- What is APY (Annual Percentage Yield)?
- APR vs. APY: Key differences
What is APR?
The annual percentage rate, most commonly referred to as APR, is the total interest you will pay annually on a loan. APR might be used in reference to a mortgage, car loan or credit card.
How does APR work?
APR differs from simple interest because it includes fees on top of the interest rate. That’s why you will see different numbers when you compare interest rates and APR. If the APR is significantly higher than the interest rate, you know you are paying a lot of extra fees.
An important thing to note is that while APR does include many fees, it doesn’t include compound interest. APR might be advertised as the true cost of borrowing, but it could still be lower than the amount you need to pay back on an annual basis.
How do you calculate APR?
Several free online calculators will allow you to figure out the APR on a loan. If you want to do it yourself the old fashioned way, here’s how:
[((Fees + Interest paid over the life of the loan)/Loan amount)/Number of days in the loan term) x 365] x 100 = APR
1. Combine the fees and interest paid over the life of the loan to determine the total cost for the borrower
2. Divide that cost by the loan amount, which is the total funds borrowed.
3. Divide that by the number of days in the loan term
4. Multiply that figure by 365
5. Finally, multiply that number by 100 to determine the annual percentage rate.
For example: You borrow $100 for 30 days. Interest is $2, and there is an additional $1 fee. If you paid back the entire amount within the 30 days, your APR would be calculated as:
[((3/100)/30) x365] x100
=[(0.03/30) x 365] x 100
= [0.001 x 365] x 100
APR=36.5%
Note that if you did not include the $1 fee, the interest rate would have been 24.33%. But, as you can see, the interest rate increases quite significantly by adding in the fee.
» MORE: How are mortgage rates set?
What is APY?
Whereas APR represents the interest you owe on loans, annual percentage yield, or APY, is used for the interest earned on savings over a year. For this reason, you also hear this number referred to as earned annual interest (EAR).
How does APY work?
APY is used mostly by banks or other financial institutions to tell clients how much interest they’ll earn on their principal. You will frequently see this number associated with savings accounts. The higher the APY, the more money you will make.
Your best bet for a high rate is to look at high-interest savings accounts. If you’re comfortable locking away your money for a pre-determined period of time, you can earn a higher-than-usual rate of interest with a guaranteed investment certificate (GIC).
Unlike APR, APY does account for compound interest. It does not, however, consider any fees, as it is in the financial institution’s best interest to make this number appear as high as possible to win your business.
How do you calculate APY?
As with APR, you should be able to find free online calculators to figure out the APY on your savings. You can also calculate APY by using the following equation:
APY= [(1 +(interest/ number of compounding periods)^ compounding periods] -1
For example: If we have $100 deposited for one year at 5% interest and that is compounded monthly your APY would be calculated as:
= [(1+(0.05/12))^12]-1
=[(1+0.004167)^12]-1
=[(1.004167)^12]-1
=1.05116-1
=0.05116
So your APY is 5.12%. Now, this doesn’t seem like a big increase of over 5% — but remember that interest will continue to compound, and you will earn more over time.
APR vs. APY: Reviewing key differences
APR and APY are two important terms to understand regarding interest rates, but because they’re used so differently, one is no better than the other.
| Stands for | Definition | What’s left out? | |
|---|---|---|---|
| APR | Annual percentage rate | Annual interest rate on money borrowed including additional fees. | The impact of compound interest. |
| APY | Annual percentage yield | Annual rate of interest earned on a savings account or GIC. | Fees. |
Even though these terms are not all-encompassing, they describe interest more accurately than a plain old interest rate. Scanning the fine print for these numbers when comparing financial products can be well worth your time. It’s better to strain your eyes than your finances.
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