Despite the fact that the only thing that APR and APY have in common is interest, people often confuse them because of their similar names. APY stands for annual percentage yield, and considers compound interest, whereas APR (annual percentage rate) does not. When applied to your account balances, APR and APY strongly influence the amount you earn or should pay. In this guide, we’ll compare the two most important financial fundamentals i.e. APR (annual percentage rate) and APY (annual percentage yield). You’ll also learn how to calculate them, and their impact on borrowing and lending.
Let’s understand the key differences between APR & APY so you can make a better & informed decision.
What is APR?
Annual Percentage Rate is the standardized way of expressing the cost of borrowing money. It includes the interest rate and other fees associated with the loan such as
- Origination fees
- Closing costs, and
- Insurance premiums
“The lower the APR percentage, the lower will be the cost of borrowing.”
It is calculated as a percentage rate for one year. As per the Lending act, APR should be disclosed by the lenders at the time of the final loan offer.
How does APR help you?
APR and interest rate together reveal a clear estimate of the total borrowing cost. Borrowers can choose the most affordable loan option using this useful tool.
The formula to calculate APR (Annual Percentage Rate):
APR = (Total Interest Paid / Loan Amount) x (365 / Loan Term in Days)
- Total Interest Paid is the amount that a borrower pays over the entire loan period.
- The loan Amount is the total amount of money borrowed.
- Loan Term in Days: This is the number of days over which the loan will be repaid.
Let’s say, you borrowed an amount of $50,000 for 3 years and paid interest of $5,000.
Then, the loan term= 365 X 3 = 1095 days
APR for this loan will be ($5,000 / $50,000) x (365 / 1095) = 0.033= 3.33%
What is APY?
APY (Annual Percentage Yield) is the total amount of interest earned on a savings account, investment, or deposit over a period of one year. Also referred to as EAR (effective annual rate) sometimes, APY is more complex than APR and comprises both:
- Frequency of compounding
- Interest rate
“Higher the frequency of compounding, the higher will be the API.”
How does APY help you?
APY is the standardized tool used by borrowers to compare investment options, savings, or potential earnings from different accounts.
How to calculate the money you’ll make with compounding interest?
Let’s take an example:
If your savings account with $5000 has an interest rate of 2% and interest is compounded monthly for 3 years, then APY would be slightly higher than 2% as the interest earned each month is added to the balance and then earns additional interest for the remaining months of the year. Below is the formula to obtain the balance.
B = P × (1 + R/N)(N × T)
- B is the ending balance that also includes the future value of the interest or loan.
- P is the original principal amount that you initially invested.
- R is the annual rate of interest for your account or investment.
- N is the number of times your interest rate is compounded.
- T is the total time duration of the investment or mortgage.
That means you’ll have a total of $5,000 × (1 + 0.02/12)(12 × 3)
APR Vs. APY: Know the Difference
Both the financial terms APR (Annual Percentage Rate) and APY (Annual Percentage Yield) refer to the interest paid on an investment or loan. But keep in mind that they are not equal and calculated differently.
On the other hand, a higher APY means that you’ll earn more from that type of financial investment, such as a deposit account or certificate of deposit.
APR is the annual interest paid by the borrower and is charged on a loan, credit card, or mortgage. It is calculated as a percentage of the principal amount borrowed without any compound interest.
Whereas, APY is the annual rate of RTI (return on investment), and considers the effect of compounding. That means APY comes into effect when your investment is growing. It reveals the total amount of interest earned on an investment or saving including the principal amount and any interest earned on the investment.
The Formula to Calculate APY:
APY = (1 + (r/n))^n – 1
Where r is the annual interest rate.
n is the number of times the interest rate is compounded annually.
How to Convert APR into APY, and vice-versa?
Both the APR & APY financial terms are used to calculate interest
The formula to convert APY to APR:
APR = (1 + r/n)^n – 1
Here r represents the APY and n is the number of compounding periods in a year.
Whereas the equivalent formula to calculate APR is:
APR = n × (1 + APY)1/n − n
Which is better: APR or APY?
Well, the decision depends on your specific goals, financial situation, and financial products that need to be evaluated.
Both the APR and APY determine interest rates on your investment, loan, or savings account; but differently. APY includes the effect of compounding whereas APR does not. Compounding is the process of calculating interest on the principal amount and on the interest earned in the previous year.
APR is used to calculate interest on credit cards, loans, and mortgages. Whereas APY is used for investment accounts, CDs, and saving accounts. Ideally, APY should be higher, and APR should be lower. APY reflects the savings that will grow with time, and APR reflects the total amount of interest that you’ll pay through the loan term.
When APR is better:
APR refers to the interest rate you will pay on the loan without any effect of compounding. It is used to review and compare different loan options as per your goals, and financial specifications.
APR (Annual Percentage Rate) is better when you are comparing two loan offers with different rates of interest using credit cards or borrowing money from different mortgage lenders.
The best deal is to get a low APR on a loan while taking into account other factors like fees, and repayment terms.
Note: APR is strongly influenced by your credit score. So it’s essential to maintain a good score as a lower credit score can lead to a higher APR.
When APY is better:
APY is one of the most important factors that help you choose from different investment options or savings. While other factors include:
- Minimum balance requirements
- Ease of access to funds.
Annual Percentage Yield is the amount of interest you earn from your investment or deposit every year with the effect of compounding. APY is better when it is higher:
- A higher APY means a higher rate of interest. So, it’s better to choose the investment options that offer high rate interest.
- If the frequency of compounding is higher, then you’ll receive interest not only on your principal amount but also on the interest rate obtained from the previous years.
- A longer investment or savings period increases the effect of compounding. Thus resulting in a higher APY.
Other factors to consider include fees, minimum balance requirements, and ease of access to funds.
FAQs about APR Vs. APY
1. What’s the big difference between APR & APY?
One of the important factors that make both APR & APY different from each other is compounding. APY is more complex and takes into account the effect of compounding whereas APR does not
2. Can I compare the same type of interest rates for APR vs APY?
Yes, but make sure you are comparing the same APR for both accounts. You can simply not compare APR for one account, and APY for another.
3. Which one should I pay close attention to, APR or APY?
Well, it depends on your specific requirements. APR is considered at the time of borrowing money. It means the interest you’ll pay throughout the loan term. On the other hand, APY represents the interest you’ll earn from your accounts or investments.
4. Do all financial institutions provide both APR and APY?
According to the law, it’s mandatory for all financial institutions to disclose both APR and APY for their financial products including mortgages, credit cards, CDs (certificates of deposit), and savings accounts.
Whether it’s about managing your finances, getting a higher interest rate on your investment, or buying a home, it’s important to understand the clear difference between APR and APY. So, you can make an informed decision, and choose the best mortgage option for you. The huge gap between APR and APY means that more often interest rate compounds.
Make sure you know the rates quoted by financial institutions; as they vary for both borrowers & lenders.
If you are ready to apply for a mortgage or refinance online, we recommend talking to our experts to know the payments, and interest rates.