At first glance, it's easy to confuse the terms APY and APR. They're both three-letter acronyms that have to do with percentages and interest rates. They're also both frequently mentioned in advertising for financial products.
However, there's a big difference when it comes to APY vs. APR. Understanding both terms can be key to making smart financial choices.
Let's delve into the question of APY vs. APR and the impact both can have on your money.
Understanding APY vs. APR: The Core Differences
APY stands for annual percentage yield. It's the percentage of interest that you can earn from a savings account, certificate of deposit (CD), money market account, or even checking account. APY always takes into account compound interest.
On the other hand, APR stands for annual percentage rate. It refers to the amount of interest you pay to borrow money. Typically, this percentage is used when banks describe credit cards, mortgages, personal loans, and other debt products. Although APR doesn't include compound interest, it does include any additional fees you may have to pay.
In other words, APY refers to the amount of money a bank or credit union pays you, while APR refers to the amount you pay your bank. Typically, the higher the APY, the better — because you can earn more money. But the lower the APR, the better because you'll be paying less money in interest charges.
APY Explained
As mentioned above, APY refers to the amount of interest an account earns over a year. In calculating APY, banks factor in the compound interest these accounts accrue. That makes APY a more accurate measure of how much you can earn from an account than just a simple interest rate.
Compound interest is the interest earned on both your initial deposit (the principal) and interest that has already accumulated. Therefore, compound interest allows your savings to grow faster — and the more often the compounding occurs, the more interest you can earn.
Banks are required by law to disclose an account's APY so that consumers can shop around to make sure they're getting the best terms possible.
The Fine Print: What to Watch out for Regarding APY
Typically, the higher the APY, the better. That’s because you'll earn more money on interest over time. However, it's also worthwhile to consider how often the bank or credit union compounds interest. Generally, the more frequent the compounding periods, the more interest you can earn.
That said, it's important to keep in mind that many banks and credit unions pay variable APYs. This means the APY may become higher or lower based on market conditions, the federal government's current monetary policy, etc. So, today's APY offered on a savings account may differ in a year.
However, some banks may offer savings products with a fixed APY — which means the rate will remain the same. Banks may also offer a fixed APY for up to a certain deposit amount. For example, an account may offer a 5% fixed APY on deposits up to $1,000. After $1,000 is reached, it may switch to a lower variable APY for all other deposits.
It's also important to understand that APY does not include any fees or early withdrawal penalties associated with the account or financial product. So, if the bank offers a high APY — but fees are also high — it might not be as good a choice as another account with a slightly lower APY but no fees.
APR Explained
APR refers to the annual percentage of interest that consumers pay on credit cards or any other type of loan. The APR is separate from the interest rate charged. The APR represents the total annual cost of borrowing, which includes the interest rate plus certain additional fees charged for the loan.
Lenders are required to report their APRs so that consumers can compare and shop around for a loan that best suits their needs.
You may also hear APRs referred to as "borrowing costs."
Unlike APYs, APRs do not take into account compound interest. With debt, compound interest means that you'll have to pay interest on any previous interest that hasn't been paid yet. This amount is added to the principal amount of the loan.
The Fine Print: What to Watch out for Regarding APR
Consumers should research loans with lower APRs. The lower the APR, the less you'll be paying in interest and fees.
That said, be sure to check the fine print on any credit card to find out whether the APR is an introductory rate that will rise after a certain period of time. The same concept applies to loans with a promotional rate.
Another consideration when comparing APRs is the type of rate – is it fixed or variable? If the APR is variable it's liable to go up and down due to market conditions, the federal government's monetary policy decisions, or other factors.
As mentioned previously, you may end up paying more in interest if you don't pay off your loan amount, leading to the interest on the account compounding. The more frequently the bank compounds the interest on the loan — semi-annually, quarterly, monthly, etc. — the more you'll pay interest on the initial principal. As a result, a loan with a slightly lower APR but a more frequent compounding schedule may cost you more over the long run than an account that compounds only once a year.
The key factor is understanding the rates and fees associated when taking on debt.
The Bottom Line
APY and APR are similar concepts in that they both express interest associated with financial products. However, these terms differ regarding how they are applied and calculated.
Typically, banks use APYs to advertise how much interest a savings product can earn for a consumer. You'll usually examine APY when comparing savings accounts, certificates of deposit, money market accounts, and even some checking accounts that pay interest. Although a few caveats are discussed above, generally speaking, the higher the APY, the better. After all, that means you'll earn more interest on your principal.
On the other hand, APRs are used to disclose the interest and fees charged on a credit card, mortgage, personal loan, business loan, or other debt instrument. Typically, the lower the APR, the lower the costs you'll pay for the loan.
Just remember the APR is different from the interest rate charged since it represents the yearly cost of borrowing the money. Also keep in mind the rate you qualify for will be based on several factors such as creditworthiness.
Unless you have chosen a product with a fixed rate, the APY or APR may be variable, meaning they can change over time. In addition, APYs and APRs may not take into account all of the fees associated with a banking product.
When considering APYs and APRs, it pays to always examine the details of the product to make sure you understand all of the costs associated with an account.
