The two terms confusing concepts of Annual percentage rate (APR) and annual percentage yield (APY) often used a lot in banking and financial industry. Having the understanding of the difference of these two can assist you in making better and more informed financial decisions. Whenever comparing APR vs. APY it refers to the periodic interest rate the bank pays you.
One key difference between the two terms is compounding. An APR does not consider compounding and in contrast, the APY does consider compounding. At most basic compounding refers to earning interest on previous interest. Let ‘s see in more detail.
APR stands for Annual Percentage Rate, which is the interest rate that is paid on an investment and it is the annual rate of interest without taking into account the compounding of interest within that year.
APY, which stands for Annual Percentage Yield, also takes into account the frequency with which the interest is applied to the investment and APY does take into account the effects of intra-year compounding.
This seemingly subtle difference can have important implications for investors and borrowers. To make it clearer the differences between the two here is an example to illustrate. A bank might charge 1% interest each month for credit card; therefore, the APR would equal 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest. The APY for a 1% rate of interest compounded monthly would be 12.68% [(1 + 0.01)^12 – 1= 12.68%] a year. If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 12%. However, if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of compounding each month.
What Banks Mostly Advertise
As a borrower, you are always searching for the lowest possible rate. When looking at the difference between APR and APY, you need to be worried about how a loan might be “disguised” as having a lower rate.
This is because banks will often quote you the annual percentage rate (APR). As we learned earlier, this figure does not take into account any intra-year compounding either semi-annual (every six months), quarterly (every three months), or monthly (12 times per year) compounding of the loan. The APR is simply the periodic rate of interest multiplied by the number of periods in the year.
In the other side, when banks are seeking customers for interest-bearing investments, such as certificates of deposit or money market accounts, it’s in their best interest to advertise their best Annual Percentage Yield (APY), not their Annual Percentage Rate (APR). The reason for this is obvious, the Annual Percentage Yield (APY) is higher, and so it looks like a better investment for the consumer.
Always Compare the Same Types of Rates
When you are looking for a new interest saving account, credit card application, investment, mortgage, loan or any financial products and services that related to interest, make sure that you are comparing apples to apples. That means when you are considering interest rates, you are comparing APY to APY. If you are comparing one account advertising its APR with another’s APY, the numbers might not reflect which account is better. When comparing the APY of both, you have a clear picture that shows which account will yield more interest. For example, the lowest advertised mortgage rate can actually turn out to be the most expensive. Many often are abused even though there are rules already in place. It is clear, banking institutions can misuse APR and APY to attempt to show potential clients that their rates are better than those of their competitors.
Both APR and APY are important concepts to understand for managing your personal finances. The more frequently the interest compounds, the greater the difference between APR and APY. All investors want to maximize compounding on their investments, while at the same time minimize it on their loans. Understanding the difference and how it works will definitely help your financial plan.