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| The Difference Between APR and APY in Interest Rates |
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Compounding interest is a strong tool for increase wealth. When interest compounds, you effectively earn interest on your interest, and the longer your time frame for investing and saving, the more potential your money has to grow.
Both APR (annual percentage rate) and APY (annual percentage yield) are commonly used to reflect the interest rate paid on a savings account, loan, money market, or certificate of deposit. It is not as of now clear from their names how the two terms — and the interest rates they describe — differ.
Understanding what APR and APY mean and how they're calculated may give you a better knowledge of just how good your money is working for you.
APR vs. APY: It’s All About Compounding
APR and APY may defined in relatively easy terms. In the context of savings accounts, the APY reflects the annual interest rate that is paid on an investment. In the context of borrowing, APR describes the annualized interest rate you pay on credit cards, loans, and other debts. It includes both the interest rate on what you borrow, also including any fees the lender charges.
- APR = Periodic rate X Number of periods per year
- APY = (1 + Periodic rate)^Number of periods - 1
A big difference between APR and APY lies in how they relate to your savings or investment growth, or the cost of borrowing.
With savings or investments, APY factors in how often the interest is applied to the balance, which may range from daily to annually. Essentially, the more frequently your rate compounds, the faster your money grows. APR doesn't work the same way.
Look at an example to show how compounding works. Say you deposit $10,000 into an online savings account that has an APR of 5 percent. If interest is only applied once per year, you would earn $500 in interest after a year.
On the other hand, lets say that the interest is applied to your balance monthly. This means that the 5 percent APR would be broken down into 12 smaller interest payments for every month.
In this case, this will amount to about 0.42 percent per month in interest. With this method, your $10,000 deposit would actually earn $42 in interest after the first month. That means in the second month, 0.42 percent would be applied to the new balance of $10,042, and so on.
Hence in this example, even though the APR is 5 percent, if interest is compounded once a month, you would actually see almost $512 of earned interest after one year which means the APY turns out to be around 5.12 percent, which is the actual amount of interest you’ll earn ,if you hold the investment for one year.
Again if you're planning an investment where the interest is applied to the balance once every year, your APR will be the same as your APY. This is not a very common scenario, however, and you're unlikely to encounter it at your bank.
Banks Mostly Advertise APY for Savers
When banks are looking for customers for interest-bearing investments, such as certificates of deposit or money market accounts, it's in their best interest to advertise their best annual percentage yield, and not their annual percentage rate.
The reason for this is very obvious: The annual percentage yield is higher, and it appears to be a better investment for the consumer. Finding a high APY should be a top priority, however, as the higher the APY, the more potential your money has to grow thanks to the compounding.
The reverse will be true with APR in a borrowing scenario, if you're getting a car loan, mortgage, credit card, or any other type of financing, you' will like the APR to be as low as possible. The lower the APR, the less interest you pay over the loan or line of credit's repayment period.
Again consider that APRs, as they're associated with borrowing, may be variable or fixed. A variable rate can fluctuate up and down over time, in tandem with movements in the index rate that it's tied to. A fixed APR, by comparison, would stay the same for the entire length of the repayment term, allowing for predictability in your monthly payments and the total amount of interest paid.
Always Compare the Same Types of Rates
When you are looking for a new savings account, CD, or money market account, ensure that you are comparing apples to apples. That means when you are considering interest rates, you’re comparing APY to APY or APR to APR, rather than blending the two .
If you're comparing one account advertising its APR with another’s APY, the numbers may not offer a true picture picture of which account is better. When comparing the APY of both, you should have a very clear picture that shows which account will yield more interest over time.
Again keep in when comparing shopping: check what traditional brick and mortar banks or credit unions offer against what you can find from online banks. Online banks tend to have lower overhead costs than traditional banks and thus are in a position to offer higher APYs on deposit accounts. Online banks may also charge fewer fees and have lower initial deposit requirements, which may also make them look more attractive than brick-and-mortar banks.
