When it comes to your financial life, it’s important to understand the difference between APY vs. APR.
To sum it up, the annual percentage yield (APY) defines how much interest you can earn on your savings and how fast your money adds up. Annual percentage rate (APR), on the other hand, determines how much it costs you to borrow money.
Here’s how to tell APY and APR apart and why it matters.
APY vs. APR: What’s the difference?
Annual percentage yield or APY is the interest you earn on a savings account, money market account, certificate of deposit, or other interest-bearing account. Annual percentage rate or APR is the interest you pay on loans or credit cards.
That’s a simple explanation, so let’s dig a little deeper. First, let’s look at the APY a savings account might offer.
When you open a savings account to build your emergency fund, for example, the bank might give you two numbers to consider. One is the interest rate and the other is the APY. The interest rate is just what it sounds like: a set percentage rate of interest you earn on the money you keep in your account.
APY, on the other hand, is a way of measuring how much you can earn on savings, based on how often your interest rate compounds. Compounding basically means earning interest on your interest, along with the interest you earn on the principal amount in your account. Depending on how your account is set up, interest might compound daily, monthly, quarterly, or yearly.
Compounding interest can be particularly powerful when it comes to investing in something like an individual retirement account or your 401(k). The longer your money compounds, the more wealth you can build, especially when you’re using automatic savings deposits to add to the principal.
APR, on the other hand, represents the cost of borrowing money annually. The APR for a loan or credit card, for instance, takes into account the interest rate, along with fees and other charges. Unlike APY, APR doesn’t compound.
Remember, the goal with savings is to get the highest APY. The goal of borrowing is the opposite. You want to snag the lowest APR to keep the amount of interest you pay at a minimum. While you may see some banks advertise a savings account APR, that’s less common than using APY. And with loans or credit cards, lenders typically focus on APR instead of APY.
Calculating APY vs. APR
If you’re borrowing money or saving money and the bank advertises both APY and APR, it’s important to do the math to see how they compare.
To calculate APY, you’d use this formula: APY = 100[(1 + r/c)c – 1]
If that seems a little complicated, don’t worry. You can easily use an APY calculator instead of crunching the numbers yourself. Essentially, what you need to know is the interest rate you’re earning and how often it compounds to see how much your money can grow.
The formula for APR looks a little different. It works like this:
APR = Fees + Interest/Principal/Number of days in the loan term x 365 x 100.
To figure out the APR, you need to know the interest rate on the loan, the fees you’re paying, the principal balance and the number of days in the loan term. Again, this is something you can use an online calculator to do.
Here’s an example to illustrate how APY and APR can make a difference with your money.
Assume that you want to invest $10,000 in a savings account with a 5% APR and a 5% APY. The APY compounds monthly. After one year, here’s how much interest you would earn, based on both APY and APR:
Now, that doesn’t seem like a huge difference. But compounding interest is really a long game. So, assume that you left that same $10,000 in a savings account earning 5% and you let it compound for five years. Even if you don’t make any new deposits, your balance would grow to $12,833.59. Over 30 years, it would increase to more than $44,000, all thanks to compound interest.
By comparison, if you were just measuring interest earned using APR, your account balance would be just $25,000. That’s because with APR, your money doesn’t benefit from the power of compounding interest over time. You’re just earning a set amount of interest each year. From a saving or investing perspective, it’s APY – not APR – that’s going to be your best friend.
How APR affects the cost of borrowing
Any time you’re thinking of borrowing money, you want to be clear on the APR. Otherwise, you could sign off on a loan or open a credit card without realizing what it’s actually going to cost you. And even small differences in the APR can make a big difference in how much you repay over the life of a loan.
For example, say you have $10,000 in credit card debt at 17.99%. If you were to pay $500 a month toward your debt, it would take you two years to pay it off. Meanwhile, you’d pay $1,978.11 in interest. Now say you owed that same balance but your APR is 16% instead. It would still take you two years to pay off the balance with a $500 monthly payment, but you’d pay nearly $200 less in interest.
Knowing the APR before you get a loan or credit card can help you shop around for the best deal. And here’s one more important thing to know about APY vs. APR. With APY, the bank sets interest rates based on a benchmark interest rate, such as the federal funds rate. With APR, rates are typically based on a benchmark like the Prime rate but the actual rate you end up with hinges largely on your credit score. The better your credit score, the lower your interest rate and the more money you save on interest.
Compare apples to apples when weighing APY vs. APR
APY and APR might seem confusing at first glance. But the most important thing to know is how they affect you financially when you borrow or save.
When trying to assess how much you’ll pay to borrow or how much interest you could earn on savings, keep it simple. Use the APR to compare loans or credit cards and APY to compare savings products. This way, you create a level playing field for weighing the pros or cons of one credit card or savings account against another.