APR vs. APY: What’s the Difference?

While APR and APY sound similar, they are quite different. APY, or annual percentage yield, refers to how much interest you earn on savings and takes into account compound interest. On the other hand, APR, or annual percentage rate, focuses on how much interest you'll pay for borrowed money.

It's easy to understand why the terms get confused. Both are used to calculate interest for investment and credit products. Both significantly affect how much you earn or must pay when they're applied to your account balances.

APR

APR is the interest you pay on a credit card or other loan, plus any fees. APR is a more accurate representation of what you pay over a year compared to simple interest, as it includes any fees. Federal law requires lenders to share their APRs with consumers to help them compare rates and shop for loans.

For example, the APR for a mortgage loan includes:

• Interest rate
• Any points (interest rate reduction for an upfront fee)
• Mortgage broker fees
• Other loan-related charges and fees

APR does not, however, account for compound interest if you don't pay off the borrowed money. At its most basic level, compounded interest is earning or paying interest on previous interest, which is added to the principal sum of a deposit or loan.

APR is calculated by multiplying the periodic interest rate by the number of periods in a year in which the periodic rate is applied. APR is calculated as follows:

APR = [((Fees + Interest/Principal)/n) x 365] x 100

Where:

• Interest = Total interest paid over life of the loan
• Principal = Loan amount
• n = Number of days in loan term
  

APY

APY shows the interest you receive over a year from certificates of deposit (CDs), money market accounts, and savings accounts. Like APR, federal law requires financial institutions to disclose the APY so you can shop around for the highest APY, which is beneficial to you. However, APY doesn't reflect any bonuses that may be provided, and special rules apply to accounts with variable APY or tiered APYs.

APY includes a calculation of how compounded interest impacts the interest rate over the course of one year. Your savings increase faster thanks to compounded interest. You'll earn more if your interest compounds more frequently. The easiest way to calculate potential earnings from APY is to use an online compounding calculator.

To calculate APY yourself: Add 1 to the periodic rate, divide that number by the number of compounding periods. Then, raise that result by the number of periods the rate is applied, and subtract 1 from that number.

APY = [(1 + r/n)ⁿ] – 1

Where:

• r = periodic rate 
• n = number of compounding periods

APR vs. APY Example

You take out a short-term personal $5,000 loan with an APR of 5%. Interest compounds monthly, but you're constantly paying down the balance with equal payments. Divided into 12 payments, you repay roughly $428.04 per month. Over one year, you'll repay $136.45 in interest.

In contrast, imagine putting $5,000 into a 12-month CD with 5% APY. It compounds monthly. At the end of the year, you'll earn $255.81 if you don't remove any of the CD's funds during the year.

The CD's interest return is higher because your money grows monthly, and you're not removing any money. With the loan, you're reducing the principal and interest that interest is charged on, even though the interest is still compounding.

The Borrower's Perspective

As a borrower, you always search for the lowest possible rate, hoping to pay less to borrow money. For instance, when you're shopping around for a mortgage, you're likely to choose a lender offering the lowest rate.

Banks often quote you the annual percentage rate on the loan or credit card. But, as we've already said, this figure does not consider intra-year compounding of the loan if you don't pay it off. It can compound daily, semi-annually, quarterly, or monthly.

This may be slightly confusing initially, so let's look at an example to solidify the concept.

Even though a bank may quote you a loan's interest rate of 5%, 7%, or 9%, depending on the compounding frequency, you may pay a much higher rate. If a bank quotes an APR of 9%, the figure isn't accounting for the effects of compounding, but it is accounting for fees and other costs.

However, suppose you were to consider the effects of monthly compounding, as APY does. In that case, you will pay 0.38% more on your loan each year—a significant amount when you amortize your loan over a 25- or 30-year period as with a mortgage.

The Saver's Perspective

As you may have guessed, if lending money (what you're technically doing by depositing funds in a bank) or investing funds, you'll want to receive the highest interest rate and benefit from frequently compounded interest.

Let's suppose that you're shopping around for a high-yield savings account. You want an account offering the best rate of return on your hard-earned dollars. Take a hard look at how often compounding occurs, along with when your account is credited. Then compare the compounded APY to other banks' APY quotes with compounding at an equivalent rate. It can significantly affect the amount of interest your savings could accrue.

The Bottom Line

Both APR and APY can help you manage your personal finances. The more frequently the interest compounds, the greater the difference between APR and APY. Whether you're shopping for a loan, signing up for a credit card, or seeking the highest rate of return on a savings account, be mindful of the different rates quoted.

Depending on whether you're a borrower or a lender, financial institutions may have different motives for quoting different rates. Always make sure you understand which rates are quoted and then look at comparable rates from other institutions.