APR vs APY: What’s the difference?
APR vs APY: What’s the difference?
APR vs APY: What’s the difference?
- APR calculates the amount of interest borrowers must pay on a loan.
- APY calculates the amount of interest investors earn during the year.
- The major difference between APR and APY is compounding interest.
Whether you’re looking to invest your money in an interest-bearing account, such as a high-yield cash account or CD, or apply for credit through a personal loan, an auto loan, a mortgage or a credit card, it’s important to understand the terms APR and APY.
While these two terms may sound similar and they’re both used to measure interest, they are very different.
This article explains the APR vs APY meaning and details how to calculate interest using both methods. Keep reading to learn more.
What is APR?
The annual percentage rate, or APR, represents the annual costs a borrower must pay for obtaining a loan. These costs primarily consist of interest, but can also include other fees and costs, such as annual fees and maintenance costs. However, some lenders charge these fees separately from APR costs. Typically, lenders express APR as a percentage they use to determine how much interest you owe.
The Truth in Lending Act of 19681 requires all lenders to clearly state the APR rate for each credit account option it offers, including credit card accounts, auto loans, personal loans, mortgages, home equity lines of credit and others. This requirement helps borrowers compare various loan options to determine which one is best for them. Basically, the lower the APR, the less you can expect to pay in interest during the duration of your loan.
It’s common practice for credit card companies to offer different APR for different transaction types. For instance, a credit card company may have a set APR, which is often prominently displayed, for standard transactions, and a higher rate for other transactions, such as balance transfers and cash advances. Some credit card companies also offer low introductory APR rates for the first few months, after which the APR will increase to the standard rate.
Bank loans offer both fixed and variable APRs. Fixed APRs remain consistent throughout the duration of the loan. Variable APRs, on the other hand, can fluctuate up and down depending on the specific index it’s tied to, such as the federal prime rate.
When obtaining a loan or opening a credit account, it’s important to understand your APR, what’s included in the rate, and if this rate can change.
What is APY?
The annual percentage yield, or APY, represents the annual rate of return an investor can expect to receive on interest-bearing accounts, such as certificates of deposits (CD), individual retirement accounts (IRA), or high-yield cash accounts. Banks and other financial institutions typically display APY as a percentage that they use to determine the amount of interest you earn during the year.
The Truth in Savings2 regulations require financial institutions to provide investors with APY information prior to opening an account. This information allows you to compare different investment options before deciding which accounts to add to your investment portfolio.
Rather than using simple interest, APY uses compound interest. This factor means the financial institution holding the account calculates earned interest on an annual basis. This interest is then added to your current balance. Typically, the higher the APY, the better rate of return you can expect to receive on your investment.
What is the difference between APR and APY?
Both APR and APY rates pertain to measuring interest, which financial institutions often display as a percentage rate. While these two rates may sound similar, they vary in several ways.
- Purpose: One of the most obvious differences between APY vs APR is that APY represents the amount of interest an investor can earn annually, whereas APR represents the amount of interest a borrower must pay annually for obtaining a loan.
- Included fees: While APR can include various administration fees, such as annual fees and closing costs, APY rates are solely based on compounding periods and don’t include any types of account fees.
- Interest calculations: APR calculations use the simple interest method, while APY calculations use compounding interest. This is an important factor to understand when obtaining a loan or credit account.
- Comparison: Comparing APR and APY rates is also very different. Because APR represents the amount of interest you owe on the loan, lower APR rates are usually better. On the other hand, APY represents the amount of interest you earn annually. So, higher APY rates are typically better.
The major difference between APR vs APY is compound interest
As mentioned above, the most important difference between APR and APY is how you calculate interest.
Financial institutions calculate APR using the simple interest method, which multiplies the standard daily interest rate by the number of days in the period. APY calculations use the compound interest method.
Compound interest is the amount of interest you earn on both your initial deposit and any earned interest from previous years. How it works is that each year, the financial institution calculates your interest earned using the compound interest method and your specific APY rate. The financial institution then adds this interest to your account, which increases the total balance in your earning-bearing account. The following year, the financial institution will calculate that year’s interest amount, using your new balance (plus any additional deposits and minus any withdrawals made during the year).
As you can see, compounding interest allows your investment to build up over time and earn you a greater return on your investment. This factor is why a higher APY rate on investment accounts is often better.
How to calculate APR and APY
The best way to understand how APR and APY impact your investment or lending decisions is to know how both measurements are calculated. Below is a look at these calculations. To make these calculations, you must first know the interest rate, represented by r in the formulas below, and the number of times the interest compounds during the year, represented by n.
The formula for calculating APR is:
[((Fees + interest) / loan amount) / length of loan terms) × 365 ] × 100 = APR
For instance, let’s say you take out a $3,000 loan that needs to be repaid within 180 days. You pay $400 in interest and $100 in other fees – your APR is 20.27%
[(($100 + $200) / $3,000) / 180) * 365))] * 100 = 20.27%
The formula for calculating APY is:
APY = (1 + r/n)n – 1
For example, let’s say your APY rate is 0.06%, and it compounds monthly,
(1 + 0.0006/12) 12 – 1 = 0.060017% APY
You can then multiply this by the balance in your account to determine the amount of interest you’ll earn. For example, let’s say you have a $50,000 balance in this account. The amount of interest you’ll receive is $30 (($50,000 * 0.060017) / 100).
APR or APY: Which is better?
It’s hard to compare APR and APY to determine which is better because they serve different purposes. A low APR is better when you’re obtaining a loan, mortgage or credit card, whereas a high APY is best for investment accounts, such as high-yield savings and money market accounts.
When obtaining a loan, such as a home mortgage or auto loan, or applying for a credit card, lenders often try to entice borrowers by offering a competitive APR. There are a few things you need to consider when comparing these rates.
First, you want to determine if these are fixed or variable APR rates. Fixed APR rates remain constant throughout the duration of the loan. Variable rates can increase or decrease depending on the market index. Some home mortgages start with a fixed APR for a set number of years before transferring to a variable rate. It’s important to realize that with any type of variable APR rate, the amount of interest you owe could increase or decrease significantly based on market conditions.
Secondly, you need to realize that the advertised APR rate will not necessarily be the rate you receive. Lenders often advertise their best APR rates, but actual rates depend on your credit report and other factors. So, while lower APR rates typically result in lower interest payments, it’s important to keep these factors in mind when comparing APR rates between different lenders.
If you’re investing in an interest-bearing account, APY rates are important. These rates determine your rate of return. Usually, higher APY rates provide a better return on your investment. However, it’s crucial to read the fine print and make sure you understand how these rates are calculated, how often interest compounds, and what fees you may incur when comparing your investment options.
Our take on APR vs APY
Whether you’re investing or borrowing money, it’s important to know the difference between APR and APY and how to calculate interest using both methods. Having even a basic understanding of these concepts can help you better compare your investment and lending options to ensure you choose the best option for you. This understanding can either help you save money by paying lower interest amounts or earn more money by selecting the option that provides the greater return on your investment.
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APR vs APY FAQs
Below is a look at the answers to some of the most commonly asked questions regarding APR vs APY.
Are APY and APR the same?
While you use both APY and APR to measure interest, they are not the same. APY determines the amount of interest you receive on an interest-bearing investment account, such as a money market or IRA account. On the other hand, APR determines the amount of interest you owe for obtaining a loan or credit card.
Why is APR higher than APY?
Typically, you’ll notice that APR rates are higher than APY rates. The reason for this difference is that lenders base APR rates on the borrower’s credit history. Customers they perceive as a higher risk have higher APR rates.
What are APR and APY in crypto?
APR vs APY crypto works the same way as it does with traditional financing. APY measures the interest investors earn on crypto savings accounts, whereas APR measures the amount of interest borrowers must pay on crypto credit accounts.
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