APR vs. APY

APR and APY are often listed as valuable points of consideration for financial products, including loans, investments and savings accounts. While they both revolve around interest, these two measurement systems have several key differences. The annual percentage rate (APR) applies to borrowed funds and is typically known as the cost to borrow. The annual percentage yield (APY) applies to investments and represents the interest earned over the course of time.

While both APR and APY measure interest, APR reflects interest charged while APY shows interest earned. These terms are used very differently and you’re not likely to find them in the same financial product. Understanding differences between the two can determine your overall interest when reviewing financial products, such as credit cards, loans and savings accounts.

The annual percentage rate (APR) is the interest paid annually on borrowed money. This rate is expressed as a percentage and is the number best used to compare different lending products.

You often find this in credit accounts, such as credit cards, car and home loans. Compared to simple interest, the APR factors in any fees included in the account — a high difference between the two simply means you're paying a lot in extra fees.

Keep in mind that while the APR is commonly used to differentiate between financial products, it is not all-encompassing. Lending institutions can exclude certain fees and the APR does not take into account compound interest. You may end up spending more than expected compared to your calculations with just the APR in mind.

Depending on the financial product, there are varying types of APR that can be used. In credit card products, APRs listed in an agreement are based on the type of charge on the account. In loans, it can vary between fixed and variable, the latter of which changes with the index interest rate. Below are a few APR types you should understand prior to applying for a credit card or loan.

The annual percentage yield (APY), also known as the effective annual rate (EAR), is the rate of return on an investment in a year with compound interest factored in. The APY includes interest earned on your total balance and with interest earned on your profits.

When evaluating investment options, reviewing the APY is a much better indicator of growth compared to simple interest because of the added compound interest. The more periods that interest is compounded, the higher the APY is, which means you’re likely to gain more on your investment.

While the APY is available in savings products, such as your savings account, certificate of deposit or time deposit, it can also apply to loans. You can use the APY to measure the annual cost of a loan with compounded interest.

Compared to APY, the APR does not take compounding interest into account; it only considers the annual interest rate. However, the APY does not take into account any extra fees involved with the financial product, which can deduct from the overall return or add to the overall cost of borrowing money.

For instance, the table below gives an overview on how monthly interest rates on a five-year financial product can change on an annual basis if it’s expressed in APR or APY.

You can also calculate compound interest to see how it impacts what you save or spend.

Banks have plenty of online tools available to calculate the APR and APY, but knowing how to do it yourself can help you quickly calculate on the spot.

To calculate the APR, compile any known fee amounts, the simple interest rate and the principal loan amount. Using the formula below, you can begin to find the APR amount. Keep in mind this formula does not account for compound interest.

APR calculation factors:

• Interest = Total interest to be paid over the life of the loan
• Principal = Total loan amount
• n = Total number of days in the loan term

To find the interest, use the following formula:

The calculation factors:

• A = Total accrued amount
• P = Principal or total loan amount
• R = Interest rate
• T = Time period or loan term

Finding a loan's APR is a great way to discover how much you’re really paying with included fees. For example, you want to borrow $5,000 and the lender’s terms are 5% interest rate for three years with a closing administrative cost of $150 and an origination fee of $200.

To find the total accrued interest over the life of the loan, you would calculate the following:

$5,750 ($5,000(1+(5%x3))=$5,750)

These are the steps to calculate this formula:

• Add 5% to the total days in the term, which is three years. 5% = 0.05 x 3 = 0.15. Then add one, which represents one year. 0.15 + 1 = 1.15.
• Take your loan amount of $5,000 and multiply it with the 1.15 which equals the interest accrued on the loan. $5,000 x 1.15 = $750.
• Add that back to the loan amount to get the total amount you will pay over the life of the loan $5,000 + $750 = $5,750.

To find the actual APR, you would also add in the fees:

• Add the fees of $150 and $200 to the interest amount.
      $705 + $200 + $150 = $1,100.
• Divide this number by the principal amount of $5,000.
      1,100/5,000 = 0.22.
• Divide the total number of days in the term, which in this case is three years.
      0.22/3 = 0.073.
• Multiply this by one year. 0.073x1 = 0.073. Then, multiply it by 100 to get the final APR.
      0.073x100=7.33%

When you're applying for a home loan, you may have two different lenders offering the same interest rate and monthly payments but different APRs. This could mean that the option with a lower APR has less fees. Review the table below to see how fees can significantly impact your APR.

Assume that you are applying for a loan of $200,000 with an interest rate of 4% and a loan term of 15 years.

If you’re evaluating a financial product and need to factor in compounding interest, knowing how to calculate the APY can help. All you need is the interest rate and the number of compounding periods.

Where:

• r = Period rate or annual interest rate
• n = Number of compounding periods

Calculating your savings account interest is a great way to determine how much you’re getting on an annual basis. For instance, imagine you are getting a 5% interest rate on your savings account with a balance of $5,000. If the compounding period is annually, then you would get an APY of 5.1% and have a total of $5,255, presuming you did not deduct from the account throughout the year.

To find the calculation, you would find the following:

The APY is the best way to determine exactly how much you’ll earn on an investment. For instance, imagine you are contemplating between a certificate of deposit (CD) that offers a 0.5% rate compounded monthly for one year versus a money market account with a 6% interest that compounds every year.

While it may seem like the both options are nearly the same — CD’s annual rate factoring to about 6% (0.5 x 12 = 6%) — when you calculate for the compound interest, the CD has a slightly higher rate. The calculation for APY would be: (1+0.005/12)^12-1 = .501% per month or 6.014% annually.

While you typically use APR for borrowed money and APY for investments, you can use either for any financial situation — just remember that they are not interchangeable. For instance, if you’re trying to factor in compound interest in your credit card, calculate the APY.

Ideally, you want to know what APR and APY are to properly manage your personal finances. This way, you can find a good APR for your credit cards or determine if an investment is right for you.

Whether you’re shopping for an auto loan or a home loan, you want to pay attention to the APR and any compounding of the loan. If there is compounding involved, make sure to calculate for the APY to find the real rate of interest.

For instance, a bank may quote you a 5% APR for a five-year, $100,000 loan. If no compounding interest is involved, you’ll pay a total of $105,000 at the end of the period. However, if it compounds quarterly, you may actually end up having a rate of 5.12% ((1+0.05/20)^20-1 = 5.12%).

By the end of the loan, you would have paid $5,120 in interest or a total of $105,120.

Ideally, you want to look for an APR that does not compound. If it does, annual compounding is better than semi-annually, quarterly or monthly compounding, as it means less chances for interest to grow.

The APR is generally the best way to measure the cost of borrowing, but there are several additional key details worth keeping in mind about APR.

Credit card agreements mention various APRs — a purchase APR, balance transfer APR, cash back APR, penalty APR and sometimes even an introductory APR. A high APR on purchases, balance transfers or cash back means that it may be hard to pay off your card balance if you only pay the minimum.

For instance, if you have a balance of $5,000 from purchases and an APR of 15% that you pay off with at least $200 each month, it would take you at least 32 months to pay it in full with $1,031 in accrued interest. If you only pay the minimum, it may take you longer to pay it off.

Understanding both APR and APY is the key to finding your ideal mortgage; otherwise, you may end up spending more if you only base your decision on initial quoted rates.

With home loan quotes you may often see the interest rate and the APR. These two are not the same. The interest shows the cost to borrow money, while the APR expresses the same but with fees and other charges involved. Such charges can include your insurance, the origination fee and lender fees.

When comparing APRs between home loan offers, the lowest is generally the best. You want to get the lowest fees and the lowest interest. However, things can change if the loan involves compounding interest. Checking for the frequency of compounds will show you what the APY will be over the course of time.

For instance, if you have a $200,000 mortgage with a 4.5% interest compounded quarterly, your APY is: (1+4.5%/4)^4-1 = 0.458 or 4.58%.

In reality, you would pay back the loan each month. The table below shows how interest compounds and your total balance accrues assuming no payments are made each quarter.

Over a year, the cost of borrowing is $9,153 or an APY 4.58%. Compounding interest increased the total cost of a loan, creating a new “real” interest rate in this example.

Prior to selecting your home loan, you should calculate the APY over the course of the loan, factoring in the number of times interest is compounded, to ensure you know the actual cost you’ll be paying. A mortgage calculator is a great tool that can help you quickly find costs associated with loan offers and lender fees.

Typically, you won’t use an APR in savings products; banks will often show you the APY instead to showcase how much you can earn from the investment. A high APY is best as it means you’ll likely receive more in return for your investment.

For example, the graph below shows just how much you can earn from a savings account with an initial investment of $10,000 and monthly contributions of $1,000 with a 0.5% annual interest rate.

In this example, the amounts are small because savings accounts do not earn much per year. Imagine if you invested the same amount in a money market account that compounds monthly with a 6% interest rate — you’d make $952 by your first year with the same contributions!

A good rule of thumb for savings accounts’ APY is to stick to somewhere around or above the national average. The FDIC’s National Rates and Rate Caps report notes that 0.06% is the national average APY for savings accounts, so try to stick to this number or higher.

Knowing and understanding what APY represents is the best way to ensure your investments are beneficial for you. With this information, you’ll be aware of how much your investment accrued in interest annually. When determining how to select the best APY for you, keep the following tips in mind:

APR and APY can be confusing terms for anyone who wants to get started with saving and investing, but understanding them is essential for making solid financial decisions. Learn more about APR and APY from the frequently asked questions below.

Learning about concepts that impact your savings or credit accounts is just as important as understanding APR vs. APY. Explore the guides below to learn more strategies to make wise financial decisions surrounding your savings, debts and investments.

• What Is a Good APR for a Credit Card? Knowing what a good APR is for credit cards can help you find an ideal option for your financial situation. Learn more about identifying good APR, how to compare cards and how to qualify for a good APR.
• How Does Credit Card Interest Work? Find out how credit card interest works, including how to calculate interest, what types of interest there are and how to avoid credit card interest where possible.
• 11 Ways to Start Saving Money: If you want to start saving but don’t know where to start — don’t worry. Learn how to save from the ground, from budgeting to consolidating debt.