Loans, investments and credit all share terms you may often encounter: the APR and the APY. Both are expressed as a percentage and have to do with interest, but there are some differences between these two. The APR is interest on borrowed money, while the APY is interest from an investment.
The annual percentage rate (APR) measures the interest charged on borrowed money, such as on loans or credit cards.
The annual percentage yield (APY) measures interest earned on investment and savings products.
Between APR and APY, only APY accounts for compounding interest.
What Is APR?
The annual percentage rate (APR) measures how much interest you pay annually on borrowed funds, including any fees charged to the account. This can be found in financial products or services such as personal loans, student loans, auto loans, mortgages and credit accounts.
A good APR is one that you can afford and does not exceed the average APR for that financial product. For instance, the average APR for personal loans is 11.23% (as of Q4 2022). Ideally, you want an APR lower or just around the average. On top of this, there are two other APRs: the introductory APR and the penalty APR.
- Introductory APR: This is a promotional APR that the lender offers for a limited time. For instance, balance transfer credit cards often have an introductory APR of 0%.
- Penalty APR: This is the APR you get if you fail to meet the agreed terms of your contract, such as if your payments are late or get returned.
It is important to keep in mind that APR does not take compound interest into account. This means it does not reflect the compounding period, such as whether it compounds numerous times during a month, quarter or year.
To come up with your APR, lenders consider a range of factors, such as:
- The type of financial product you’re applying for
- The type of interest (variable or fixed)
- The loan term
- Your credit score
- Your debt-to-income (DTI) ratio
- The amount you’re borrowing
- Your payment history
- Your down payment (for mortgages)
- Your location (for mortgages)
There may also be other factors involved in your lender’s APR calculation process, as it can vary from lender to lender. However, some factors not included in your APR calculation are your:
- National origin
- Sexual orientation
- Gender identity
How Is APR Calculated?
To calculate your APR, all you need is:
- The total interest paid over the life of the loan
- The principal
- The number of days in your loan term
The formula to get your APR is:
APR = ((fees + total interest paid over the life of the loan ÷ principal loan amount) ÷ number of days in your loan term)) x 365 x 100.
Before calculating your APR, you need to know the total interest you will pay over the life of the loan. To calculate this, you will need to follow this formula:
Interest = (Principal loan amount x (1 + [interest rate x loan term])
For instance, if you want to get the APR of a $10,000 loan with a 5% interest rate for five years with an origination fee of $150, you would calculate it as such:
Total interest paid over the life of the loan = ($10,000 x (1 + [0.05 x 5]) = $2,500
APR = ((([[$150 + $2,500] ÷ $10,000] ÷ 1,825 days) x 365) x 100) = 5.3%
As long as you follow the formula and have the necessary information, you’ll be able to calculate your APR. Keep in mind that APR does not account for compound interest, meaning it does not show the reality of how many times the interest will be compounded in a year and how that can grow.
Lenders often promote financial products with APR to inform you about what you’re paying. Some popular financial products that are expressed with APR include:
- Personal loans: A personal loan is a lump sum of money you can borrow for virtually any purpose.
- Student loans: These are loans used specifically for educational expenses.
- Car loans: These are funds you borrow to purchase a car.
- Mortgages: Mortgages are loans meant to buy a home.
- Credit cards: A credit card is a line of credit that allows you to draw money only when you need it up to a limit set by your provider.
What Is APY?
The annual percentage yield (APY), also known as the effective annual rate (EAR), is a percentage often used in investments like a government bond, a certificate of deposit (CD) or a savings account. It represents the yearly rate of return on an investment while taking into account compound interest.
Looking at an investment’s APY is a convenient way to determine how much you’ll make over time as you let your principal balance and profit compound. Generally, the higher the APY, the more you stand to earn.
How Is APY Calculated?
To calculate your APY, you will need:
- The interest rate
- The number of compounding periods
The formula to get your APY is:
APY = (1 + ( r ÷ n))^n - 1
- “r” equates to the period rate or interest rate
- “n” equates to the number of compounding periods
Thus, if you have a savings account with a 3% interest rate that compounds monthly, your APY would be 3.04%. This is computed by:
APY = (1 + (0.03 ÷ 12))^12 - 1 = 0.0304 or 3.04%
If you have the interest rate of your desired investment account and the number of times a year it compounds (be it annually, quarterly or monthly, weekly or daily), you will be able to compute your APY.
Using an APY is a more accurate way for banks to express your potential gains in an investment. Some investment products that use an APY include:
- Certificate of deposit (CD): A CD is a long-term savings product where you can earn interest on a lump sum for a certain period of time.
- Money market account (MMA): This financial product combines features from both savings and checking accounts, often also coming with higher interest rates compared to traditional savings accounts.
- High-yield savings accounts: These are savings accounts with higher interest rates compared to traditional savings accounts but may have different initial deposit requirements, minimum balance requirements and fees.
Key Differences in Compounding Interest
There are two main differences between APR and APY: their purpose and compounding interest. APR measures interest on borrowed money, while APY measures interest on invested money. APY also takes into account compounding interest, which APR does not.
The compound interest effect is the process of the initial amount growing upon itself and gaining momentum over time. It can be a powerful tool to determine growth in saving and investing or a challenge to tackle when it comes to repaying debts. On the flip side, APR only measures simple interest, which is what is owed from the principal amount.
APR is typically mentioned with financial products that loan money to allow you to determine the cost of borrowing. For instance, if you take out a $1,000 loan and the APR is 5%, the “cost” you are paying to borrow is $50. This will typically remain the same up to the end of the term.
Conversely, APY is mentioned with investment and saving products to help you understand how much you can gain even over the years. For instance, if you invest a principal of $1,000 and have 5% APY, you’d earn $50 in the first year, $52.50 in your second year, and so on. This is because your earnings every year get added to your principal amount, assuming you are not taking out any money from your savings.
Understanding the differences between APR and APY can help you determine what you’re dealing with, whether that be loss or growth.
Factors to Consider When Comparing APR and APY
Knowing what APR and APY is can impact the way you view loan products and investments. Below are a few tips to keep in mind.
Compare products and their APR or APY
Whether you’re saving, investing or borrowing money, compare their respective APR or APY. For instance, don’t opt for the first APR you see on a credit card — shop around before applying.
Research how APR and APY impact products
Have a concrete understanding of how APR and APY can impact your desired financial product. For instance, learn what can impact the APR of a personal loan.
Consider the frequency of the compounding interest
If you’re looking at investment products and their APY, make sure to understand how often the interest compounds. Is it daily, weekly, monthly or annually?
FAQs About APR and APY
Understanding financial jargon like APR and APY can be helpful throughout your dealings with loans and investments. Learn more about the differences between the two through our frequently asked questions.
- Federal Reserve. "Consumer Credit - G19." Accessed January 6, 2023.
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