3 Key Differences Between APR and APY You Need To Know

When it comes to saving or borrowing money, understanding the difference between APR and APY is crucial. Both APR and APY represent interest rates, but they calculate interest differently.

APR vs. APY: Definitions

APR (Annual Percentage Rate) is a simple interest rate that does not include the effect of compounding. It represents the annual cost or return on a loan or savings account without considering the frequency of compounding.

APY (Annual Percentage Yield), on the other hand, considers the effect of compounding and provides a more accurate representation of the actual interest earned or paid over a specific period. Compounding refers to the addition of interest earned to the principal, which then earns interest in subsequent periods.

APR vs. APY: Formulas

The formulas for calculating APR and APY are:

APR = (Total Interest Paid or Earned / Principal) x (365 / Loan Term or Savings Term)

APY = (1 + (APR / Number of Compounding Periods))^Number of Compounding Periods - 1

3 Key Differences Between APR and APY

1. Compounding: APR does not consider compounding, while APY does. This means that APY accounts for the snowball effect of interest earning interest, resulting in a higher effective interest rate.

   

2. Time Period: APR is typically quoted as a yearly rate, while APY considers the actual time period over which interest is earned or paid. This can be daily, monthly, or quarterly compounding.

3. Impact on Interest Earned/Paid: Due to compounding, APY generally provides a higher interest rate than APR. This is because the interest earned in one period is added to the principal before calculating the interest for the next period.

Why the Difference Matters

Understanding the difference between APR and APY is important for several reasons:

1. Accurate Interest Calculation: APY provides a more precise estimate of the actual interest earned or paid over a given period, especially for long-term investments or loans.

2. Informed Decision-Making: Comparing APR and APY allows you to make informed decisions about savings and borrowing options. Choosing an account with a higher APY can significantly increase your earnings over time.

3. Loan Repayment Planning: Understanding APR and APY helps borrowers estimate the total cost of a loan, including interest and fees. This information is crucial for budgeting and ensuring that loan repayments are affordable.

Example: Calculating APR vs. APY

Consider a savings account with an APR of 2%.

APR Calculation:

APR = (Total Interest Earned / Principal) x (365 / Savings Term)

Assume a $1,000 deposit for one year.

APR = (0.02 x $1,000) x (365 / 365) = 2%

APY Calculation:

APY = (1 + (APR / Number of Compounding Periods))^Number of Compounding Periods - 1

Assume monthly compounding.

APY = (1 + (0.02 / 12))^12 - 1 = 2.02%

As you can see, the APY is slightly higher than the APR due to the effect of compounding.

Tips for Maximizing Interest Earned

1. Choose Accounts with High APYs: Look for savings accounts and certificates of deposit (CDs) that offer competitive APYs.

2. Consider Compounding Frequency: Opt for accounts that compound interest more frequently, such as daily or monthly.

3. Make Regular Deposits: Contributing to your savings regularly increases the principal, which in turn earns more interest.

4. Avoid Early Withdrawals: Withdrawing funds before the end of the term can result in penalties and forfeit earned interest.

5. Explore High-Yield Savings Apps: Some mobile banking apps offer high-yield savings accounts with competitive APYs.

Conclusion

Understanding the difference between APR and APY is essential for managing your finances effectively. APY provides a more accurate representation of the actual interest earned or paid, and it should be considered when comparing savings and borrowing options. By choosing accounts with high APYs and utilizing compounding, you can maximize interest earnings and achieve your financial goals faster.