APR vs. APY: How they’re different and why they matter

Content Type: Article

What you need to know about these essential money terms.

When it comes to money and loans, people face a seemingly impenetrable alphabet soup of terminology, starting with “APRs” and “APYs.” Whether you are borrowing money or investing it, understanding bank-speak will allow you to properly assess your options and pick the ones that make the most sense to you. The following details are meant to help you demystify the terms “APR,” “APY” and “interest rate.”

The first thing you should think of is whether you are spending money or saving money.

Spending money: On the spending side, if you’re using credit to buy a house, a car or any other good or service, you’ll want to know a loan's APR, or annual percentage rate, not just its interest rate. Knowing the difference between these terms before loan shopping ensures no surprises when you get the bill.
Saving money: If you have a bank account or other investment through which you receive a fixed stream of interest income (and your principal returned down the line), the APY, or annual percentage yield, takes on more importance than the interest rate you’re receiving on the loan. The distinction—in your favor—means more money in your pocket. This is money you earn.

Let’s have a closer look:

Interest rate (spending)

When borrowing, the interest rate on a loan determines the base amount of money you will pay to the lender on the loan’s outstanding principal each year, but probably not the rate at which you will actually pay. That’s because the interest rate used to calculate the repayment won’t include any extra related costs, which are included under the APR.

Example: Let’s say you took out a $20,000 personal loan that carried no extra fees, and you promised to pay back $21,000 in a lump sum a year later. That $1,000 is equivalent to a 5% interest rate. (Remember to check in advance if the terms of your loan allow for early pay back.)

APR

The APR is more significant than the simple interest rate, as it measures a loan’s overall cost, factoring in not just the interest rate but also any additional finance charges and related fees. Interest rates among financing options may be the same, but if the APRs are different, the repayments will be different as well. Sometimes, one loan option might have a higher interest rate than another, but a lower APR after fees for the same amount of principal. The APR is key.

(Note: With credit cards, the interest rate is the APR and only comes into play when balances are not paid in full each month. Credit card APRs may differ for late payments, cash advances or balance transfers.)

Example: Let’s say that, like before, you borrowed $20,000 on a personal loan for one year at a 5% interest rate, but this time, the lender demanded an origination fee of $500 off the top. You would then receive $19,500, but because you’re still paying back the lump sum of $21,000, the 5% interest rate you thought you were paying turns into an APR of roughly 9.6%.

Interest rate (saving)

If you have money in an interest-bearing bank account or investment product such as a certificate of deposit, then the interest rate in these cases determines, to a large extent, the amount of money paid to you. The interest rate used to calculate your return does not, however, include compounding, which is included under the APY. (Compound interest reflects earnings not only on your original investment but also on the interest income you’ve already earned on the investment.)

Example: You buy a $10,000 one-year certificate of deposit that carries an interest rate of 5%. In a year, you will receive your $10,000 back plus $500, or $10,500. The interest has not compounded.

APY

The APY will be higher than the interest rate because your interest is, in effect, earning interest itself. It’s important to compare apples to apples when you are considering investment options, as the frequency of the compounding will determine your exact APY. Compounding may take place daily, monthly, quarterly, etc.

Example: You buy a $10,000 one-year certificate of deposit that would nominally have an interest rate of 5%. However, if compounded daily, the APY on your $10,000 will be not 5%, but 5.127%. If monthly, 5.116%; if quarterly, 5.095%. A year later, you would receive your original $10,000 plus interest of $512.67 if compounded daily; $511.62, if monthly; and $509.45, if quarterly.

As you can see, when it comes to APRs, APYs and interest rates, paying attention to the details really matters. A firm grasp of the differences between them will allow you to more effectively comparison shop, spending less and saving more.