Interest rate is a key figure to know, whether you’re borrowing money or investing it. But as you shop around for the best financial product for you, you will probably find that two different abbreviations are used to demonstrate the interest rate – APR and APY.
You’re probably familiar with the terms annual percentage rate (APR) and annual percentage yield APY, but what makes them different? Here’s everything you need to know.
So, what’s the difference between APR and APY?
When you open an investment account, you will earn interest. Similarly, when you take out a loan, you will be charged interest. During either of these instances, you will see either the term APR or APY to describe your interest. While these terms are only one letter apart, they offer very different outcomes.
The biggest difference is APR is what you earn annually, without calculating compound interest. Conversely, APY includes compound interest.
This is a huge difference, because compound interest can really work for you if you are saving money, or work against you if you are taking out debt. The way it works is interest compounds, or simply adds up, and is then added to your principal balance. This action is called compounding. This works for you with your investments, because essentially, you can earn interest on your interest.
However, this really works against you if you have, say, credit card debt. In fact, many credit card companies compound interest on a daily basis. The companies will take your principal balance, or the total amount you owe, and multiply it by the interest rate. They will then add that amount to your principal balance. This is one reason why so many people find it difficult to get out of credit card debt. The amount you owe can grow very quickly if you aren’t making regular payments.
If APY compounds more than once a year, it is typically going to be higher than APR, since APR is based on one year increments. However, some APY accounts only compound interest once per year, so in that event, they would be equal.
APR versus APY…does it really make that big of a difference?
In short, yes! Let’s say you have $5,000 you were saving in an emergency fund. Now that you’ve reached your goal, you want to put your money into a high-yield savings account, so you can access it as needed, but still earn interest on that cash.
As you shop around, you find two seemingly similar banks. They both offer a 2.00% interest rate. But one offers 2.00% APR which compounds just once a year. The other offers 2.00% APY, but it compounds every month.
Now, let’s see this amount in action. If you invest in bank account number one, you would earn $100 on your initial $5,000 investment ($5,000*.02=$100). At the end of the year, your total balance would then be $5,100, assuming you didn’t spend any of your funds throughout the year.
On the other hand, calculating your APY for bank account number two isn’t so simple, but here’s an example. The formula to calculate APY is as follows:
APY = 100[(1 + r/c)c-1]
In this equation, “r” represents the interest rate, and “c” stands for how many times your interest compounds per year. But don’t worry if math isn’t your favorite subject – there are plenty of free online calculators that can easily calculate APY for you.
By using this formula, you can see that your initial $5,000 investment would become $5,100.92 at the end of the year. While this doesn’t seem like a major difference, remember, this is a small example that is just demonstrating one year. If you continued to add money to that account and didn’t touch it for years, it would continue to grow at a much faster rate than if you just had an account that only compounded once per year.
Find the best option for you
Now that you know how to calculate APR and APY, you can compare the two when you shop around. The important thing is to compare every rate to see what the best option is for you. And remember – even if the difference seems small, overtime, it can really add up!
Have you experienced the difference between APR and APY? If so, what are your favorite tips for taking advantage of your interest earned on an investment?
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