You’re careful to shop for the lowest interest rates on credit cards and loans, and you go out of your way to find the savings accounts that offer the highest returns.
But not all interest rates are created — or calculated — equally.
We’re talking about the difference between APY and APR, and how that one little letter can make a difference.
APR vs. APY: What’s the Difference?
What is APR, and what is APY? APR (annual percentage rate) and APY (annual percentage yield) are both used to describe interest percentages. Interest is the amount of money you pay over time on a debt you owe, or the amount that is paid to you over time when you deposit money.
But here’s the thing: A 10% APR and 10% APY aren’t exactly the same thing. In fact, in many cases, there can be a fairly significant difference.
That’s because of the effects of compounding, or the frequency with which interest is added to your loan balance or bank account. Interest can compound daily, monthly, quarterly or even yearly, but whenever it’s compounded, it becomes part of your total balance — which pushes the next term’s interest calculation that much higher.
What Is APY?
Annual percentage yield, as its name suggests, takes into account the entire amount of interest generated over the course of a year. For this reason, it’s also sometimes called “earned annual interest,” or EAR.
That means APY does take compounding into account when it’s calculated. The frequency at which interest is applied is already built into the figure, so you know exactly how much interest you’ll owe or earn at the end of one year’s time.
What Is APR?
Annual percentage rate, on the other hand, does NOT take the effects of compounding into account. And you may have to do a little digging to learn how often your loan is compounded.
The information will be buried somewhere in that monolithic stack of paperwork you have to sign to take out the loan. You can also ask the lender directly how often the loan is compounded, and we highly recommend you do so before you sign any paperwork.
A loan may compound on a yearly basis, which would effectively mean the APR and APY percentages are equal. But in most cases, they compound more frequently — monthly or even daily — which could mean you pay more in interest over time.
APR is more likely to be seen on financial products that cost you money over time, like a mortgage, auto loan, or consumer credit card.
But you’re more likely to see APYs advertised on products that help you earn money through accrued interest, like a certificate of deposit or savings account. Lenders almost never express their interest rates in APY — because they can make the cost look lower by using APR instead.
Why Does Compounding Matter?
You may already see where this is going, but here’s what makes APR so tricky: Whenever your loan is compounded, that interest is added onto your total debt — which means the effective amount of interest you pay during each compounding period keeps growing.
So the 10% APR we mentioned earlier actually works out to 10.51% APY when interest is compounded daily, which many credit cards do.
Conversely, of course, compound interest can also work in your favor when you’re using it to grow your retirement fund or other investments. However, the percentage you see on high-growth savings account is usually in APY — which means that 5% is 5% for the year, total.
APR vs. APY: Comparing Apple to Apples
Since these two measures are so different, why are both in use?
It all comes down to marketing. Lenders know that listing interest in APR can make it look like you won’t pay as much interest over time, whereas those offering an investment opportunity want to make the interest payout look as high as possible.
So how can you ensure you don’t end up on the wrong end of the APR vs. APY equation?
The answer lies in an actual equation, by which you can calculate the APY out of an APR rate.
That equation is: APY = 100[(1 + r/c)c – 1], where “r” represents the APR (expressed in decimal form) and “c” represents the number of times per year your interest compounds. For example, if your interest compounds quarterly, c=4; if your interest compounds daily, c=365.
However, if you, like me, get minor tremors just looking at something this algebraic, fear not: You can also run your loan terms through a handy-dandy online loan calculator.
Bottom line: Make sure you understand exactly what you’ll pay (or receive) over time before you sign any paperwork… even if that means doing some math. Your future self and your bank account will certainly thank you later.
Jamie Cattanach’s work has been featured at Fodor’s, Yahoo, SELF, The Huffington Post, The Motley Fool and other outlets. Learn more at www.jamiecattanach.com.