APR vs APY--What's the Difference?

Mastering Your Money: Understanding the Difference Between APY and APR

When it comes to financial terms, it’s easy to get overwhelmed by the sheer number of new vocabulary words you need to understand. In addition, there are a number of acronyms that get tossed around in conversations about finances that confuse matters even further. Two such terms are APR and APY. While these sound similar, they’re generally used for two very different purposes. 

In this article, we’ll dig into the distinction between the two, explain why they matter, and equip you with a little bit of knowledge to help you make better financial decisions. 

The Basics of APY: A Savings Powerhouse

APY stands for Annual Percentage Yield, and it's a figure you'll frequently encounter when researching savings accounts. Basically, the “yield” is how much an account will pay for the opportunity to store your money. You’ll generally see it in the context of deposits such as savings accounts, CDs, and other interest-bearing savings options like money market accounts.

What Exactly is APY?

The Annual Percentage Yield tells you the total amount of interest you will earn on your deposit over the course of a year, taking into account the interest compounding effect and assuming you don't make any deposits or withdrawals. For example, imagine you put $1,000 into an account with a 5% APY. At the end of one year, your money would have earned $50 in interest.

The Compounding Effect

Interest compounding might sound complicated, but at its core, it means earning interest on both the initial deposit as well as the interest that has already been earned. This can lead to substantial growth in your savings over time.

Let’s look at our imaginary $1,000: At the end of one year, you’d have an additional $50. During the second year, you would earn interest not only on your original $1,000, but also the $50 in interest. That means that at the end of the second year, you would have not only the second year’s $50 from your original investment, but an additional $2.50 from interest earned on the extra $50. Here it is in table form:

An initial investment of $1,000 compounded annually at 5%:
Initial Amount	$1,000
After 1 year	$1,050
2 years	$1,102.50
3 years	$1,157.63
4 years	$1,215.51
5 years	$1,276.29
6 years	$1,340.10
7 years	$1,407.11
8 years	$1,477.47
9 years	$1,551.34
10 years	$1,628.91

While that initial $2.50 may not seem like much, over the course of 10 years you can really start to see its effect. And this is assuming you only ever make one deposit, and the interest is compounded annually. Most accounts will compound more frequently than once per year.

How Frequency of Compounding Makes a Difference

The more often the interest is compounded, whether it’s daily, monthly, or annually, the more your money grows. A savings account with a high APY that compounds daily will accrue noticeably more interest over time than an account with the same APY that compounds monthly or annually. Even a fraction of a percentage point difference in APY can add up to significant earnings over the course of several years.

Let’s look at the same example above, but this time compound the interest monthly:

An initial investment of $1,000 compounded monthly at 5%:
Initial Amount	$1,000
After 1 year	$1,051.16
2 years	$1,104.94
3 years	$1,161.47
4 years	$1,220.89
5 years	$1,283.35
6 years	$1,349.01
7 years	$1,418.03
8 years	$1,490.58
9 years	$1,566.84
10 years	$1,647.00

See the difference? And remember, this is for an account with only an initial deposit. If you make regular contributions to this account, the number will increase even faster as you earn interest on your new deposits as well.

Seeking High APY for Wealth Building

If you’re a saver or an investor, a high APY is a launchpad for your savings, accelerating their growth. The higher the APY, the more interest you can earn with the same deposit amount. This is why understanding and comparing APY is vital for anyone looking to open a savings account to set money aside for a goal or emergency fund.

APR: Understanding Borrowing Costs

APR, or Annual Percentage Rate, is another essential number to understand when it comes to financial decision-making. While APY usually focuses on the interest earned on the money you save, APR is generally used when talking about the cost of borrowing money. 

Understanding APR in Lending

If you’re looking to borrow, whether it’s a mortgage, personal loan, or credit card, the Annual Percentage Rate will tell you how much you’ll pay in interest costs. It represents the annual interest rate, including any additional fees. Unlike APY, where a higher number is better, a lower APR is more advantageous for borrowers.

It's More than Just an Interest Rate

When you take out a loan or use a credit card, the APR gives you more transparency of the account costs, combining the base interest rate with any origination fees or other charges required for the loan. This gives you a more comprehensive view of the cost of borrowing money over the course of the year.

Lower APR, Lower Cost of Debt

The principle with APR is simple: the lower the rate, the less you’ll pay in interest over the life of the loan. For big-ticket items like homes and vehicles, even a fraction of a percentage point difference in APR can translate to thousands of dollars in savings.

A Word of Caution for Mortgage Shoppers

When it comes to mortgage loans, you may find that the APR doesn’t always give you the full picture. For example, adjustable-rate mortgages (ARMs) don’t have a constant interest rate over the life of the loan, so the APR may underestimate the cost of the mortgage if rates rise in the future. In addition, some mortgages include different fees when calculating the APR, so if you’re comparing rates, you’ll want to be sure to find out which fees are included in the calculation.

Applying Your Knowledge of APY and APR

APY and APR are both essential financial metrics with one significant difference: they benefit different sides of the financial equation. Understanding the distinction between these figures is crucial in making informed decisions for your money.

Focused on Savings? Think APY

When it’s all about growing your savings, APY is the magic number to compare. Look for options with higher APY and frequent compounding to give your nest egg an extra boost.

Considering a Loan? Mind the APR

On the flip side, if you’re in the market for a loan, whether it’s for a credit card, education costs, a car, or a home, pay close attention to the APR. Lower rates result in less money paid to the lender over time, reducing both your monthly payments and the overall cost of the loan.

Use your Resources

Online calculators and tools can help you visualize the impact of different interest rates and compounding scenarios. These resources will show you exactly how even slight changes in APY and APR can have significant long-term effects on your finances. 

Knowledge is Your Financial Superpower

Understanding APY and APR and when to use them can be transformative for your finances. Whether you’re a saver or a borrower, you’ll be able to make informed decisions and harness the benefits of interest rates in a way that serves your financial objectives, whatever they may be.