Investments

What Is The Difference Between APR And APY

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 4 minute read

Can you please explain the distinction between annual percentage rate and annual percentage yield? Many people either don’t comprehend or completely ignore the dozens of acronyms that appear in advertisements and legal documents. 

The ability to recognize the distinction between annual percentage rate (APR) and annual percentage yield (APY) is a fundamental requirement for anyone who plans to manage their own personal finances.

To better comprehend an interest rate, you need to be aware of both the annual percentage rate and the annual percentage yield. The annual percentage rate (APR) is used by borrowers to get a sense of the true cost of a loan, whereas the annual percentage yield (APY) is more common among investors.

APR (Annual Percentage Rate): Interest Rate and Fees

The interest rate on a loan, along with any fees that may be associated with it, may add up to a lot of money over the course of a year, and the annual percentage rate (APR) is a useful way to keep track of that. 

It’s a metric for estimating how much money you’ll spend on your loan. The annual percentage rate (APR) is expressed as a percentage of the loan’s principal (the amount you borrowed) every year.

The annual percentage rate (APR) of a loan is determined by dividing the sum of all fees and interest paid throughout the life of the loan by the loan’s principal. A final annualized rate represented as a percentage is calculated by multiplying this figure by 365 and then by 100.

As an illustration, if the annual percentage rate (APR) on your loan is 10% and your loan balance is $1,000, your annual interest payment will be $100. Your payments of $200 per year will go just toward the debt and the interest.

Since APR doesn’t reveal the impact of compounding, it has a major drawback. Since high-interest rates may rapidly increase the principal while you are trying to pay it down, using the APR to calculate how to pay off your credit card debts would likely lead to inaccurate results. 

However, the annual percentage rate (APR) provides a fair means to compare the expenses or rates offered by different lenders.

Compounding Yields are Measured by Annual Percentage yield (APY).

An investment’s true return can be shown in the annual percentage yield (APY). The algorithm used to calculate APY automatically accounts for compound interest. When interest is compounded, it is calculated on both the outstanding principal and any interest that was accrued but not paid during the prior compounding period, creating “interest on interest.”

To determine the APY, divide the annual interest rate by the number of times per year that it is compounded by 1. Then, if there are 12 compounding periods in a year, the sum is multiplied by 12 to account for the additional growth that occurs throughout each period. 

Finally, a percentage yield represented as an annual rate is obtained by subtracting 1 from the final value. Interest rates will be calculated slightly differently using the APR and APY formulas on the same example unless yearly compounding is used in the first year. 

When compounded over a longer period of time, APY will exceed APR. The difference between the APY and the APR will increase proportionally as the interest is compounded more frequently.

Since the APR effectively displays the periodic rate, which may or may not be the same as the annual interest rate, this is the case. Annual interest rate divided by the number of payments made each year yields the periodic rate. Therefore, if your yearly interest rate is 13%, your monthly interest rate will be 1%. 

The yearly effective rate calculated by the APY calculation depends on whether or not that 1% interest per month is compounded. The effective annual percentage yield (APY) is sometimes more useful than the annual percentage rate (APR) for a long-term understanding of many financial instruments. 

The difference between the annual percentage rate (APR) and the annual percentage yield (APY) can be substantial, making it difficult to determine the true cost of borrowing money.

The Overall Effects of APR and APY

There are situations in which either APR or APY would be more appropriate. By calculating the annual percentage rate (APR), you may get a decent estimate of what your monthly payments will be, which is useful for figuring out how a loan will affect your finances. 

The annual percentage yield (APY) is a more strategic way to look at your investment returns and debt costs over the long run. APR is useful for a more tactical perspective, whereas APY provides a more macro one.

What to Look Out For

If you try to compare annual percentage rates (APR) with annual percentage yields (APY), you will get misleading results. You should only compare services while looking for the best prices.

These two rates, along with additional words like current rates and effective rates, are sometimes included by financial institutions such as local credit unions or firms marketing sophisticated financial products to make comparing unlike goods more difficult. 

It’s a frequent sales strategy to make it seem like things are better than they actually are by obscuring the rate at which interest is accrued in your favor or the rate at which debt or costs compound against you.

Advertised annual percentage rates (APRs) on credit card offers and other forms of debt from banks and credit unions are designed to hide the true cost of borrowing money. In contrast, the significance of the interest or profits compounding for you is highlighted by practically every savings or investment choice by advertising its APY.

Bottom Line

You can better understand the interest rates on the financial products you use if you are familiar with both the annual percentage rate (APR) and annual percentage yield (APY). 

Keep in mind that salespeople may try to exploit either of these figures to make a sale, even if they don’t provide the whole truth about how much your fees or interest would increase over time.

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