Buzz
Interest can accumulate quickly. When borrowing or saving, it’s essential to know your interest rate. The catch is, there’s APR and APY. These two terms differ, and many people don’t understand the distinction.
Grasping how these terms function is key to understanding what you’re dealing with.
Annual Percentage Rate (APR) refers to the interest rate expressed as an annual rate; it's simply the interest rate multiplied by the number of periods in a year. For instance, if your credit card’s monthly rate is 1%, your APR would be 12%. APR is commonly linked to borrowing money or credit card use. When it comes to mortgages, APR also factors in any loan-related fees, unlike the simple interest rate which only includes the interest.
Annual Percentage Yield (APY) measures the return on an interest rate, accounting for compound interest. Compound interest is interest earned not just on the original principal but also on the interest that’s already been added. We've explained it further, but it’s essentially interest earned on accumulated interest.
APY is linked to savings. It takes the interest rate into account and considers the frequency of interest compounding over the year to calculate a percentage. Ally demonstrates how this works:
APY = (1 + Periodic Rate as a decimal)
The Number of Periods in a year
- 1
Let’s now examine how a periodic rate compounded yearly compared to compounded monthly affects APY when the periodic rate (typically referred to as the “rate”) is 1.32%:
Rate of 1.32% compounded annually:
(1 + .0132)1 -1 = .0132 or
1.32% APY
If your initial deposit was $1,000, you would have $1,013.20 after one year
Rate of 1.32% compounded daily:
(1 + 0.0011)365 -1 = .01329 or
1.329% APY
If your initial deposit was $1,000, you would have $1,013.29 at the end of the year
In simple terms, APY indicates how much you will earn in interest over a year. On the other hand, APR shows the amount of interest you pay annually on loans or revolving credit. When comparing loans, credit card deals, or savings accounts, it's vital to ensure you're comparing similar options.
Update: We've revised the article to clarify the initial information from Investopedia. Special thanks to reader FinanceGuy44 for pointing this out.
Image by HeatherPaque.
