APR and APY are two very different terms used in interest calculations. It is very easy to get confused even…

APR and APY are two very different terms used in interest calculations. It is very easy to get confused even if you’re financial savvy. Remember, not understanding the proper financial language and terms can cost you money. This article attempts to clear up the difference between APR and APY and should come in handy when you shop for a loan or looking to deposit money in a saving or money market account.

APR stands for Annual Percentage Rate while APY stands for Annual Percentage Yield. These two terms are very common and are used everyday by financial institutions. Bank and financial institutions will quote you the term that favors them most. They would not tell you the difference unless you insist and even then explanation might be too difficult for you to understand because they don’t want you to understand!. In simple terms, APR is the annual percentage rate that applies for your deposit or loan while APY is the total interest earned during the year. APR does not consider the compounding interest into account while APY does. You might still be thinking “How does it can cost me money?” Well, Here is an example to help explain this difference.

Let’s say you purchased a $10,000 CD with 5% APR with a maturity period of 5 years. At the end of first year, you’ll earn an interest of 5%($500). This example assumes that your interest is earned annually. So for the first year, APY is equal to APR. However, this will change next year as 5% interest will be calculated on $10,500 for next year. Interest earned during second year is $525 and thus yield this year is 5.25%, higher than APR that remains fixed throughout the period. Banks or financial institutions can calculate the total yield over the life of loan or deposit and can quote you that number. One of the important thing to pay close attention is how your APR is applied. If it is applied at smaller intervals, it could push the yield a lot higher and you could earn more in interest.

Now here is another example that should clear things up. If your credit card charges 1% interest each month; therefore the APR would equal 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest. The APY for a 1% rate of interest compounded monthly would be [(1 + 0.01)^12 – 1= 12.68%] 12.68% a year. If you only carry a balance on your credit card for one month’s period you will be charged the equivalent yearly rate of 12%. However if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of the compounding each month.

Now how do we calculate APY? As you can see APY is the interest calculated using compounding. Following formula can be used to calculate APY on any loan or deposit. Where APR = Simple interest rate, Total period = No of period calculated over the length of time. So if we consider our credit card example, APY = (1+ 1/100)*12 – 1 = 1.1268 – 1 = 0.1268 or 12.68%

How does APY affect you will depend whether you’re a borrower or a lender. As a borrower, you are always searching for the lowest possible rate. When looking at the difference between APR and APY, you need to be worried about how a loan might be “disguised” as a lower rate than it really is. For example, when looking for a mortgage or credit card you are likely to choose a lender that offers the lowest rate. Although the quoted rates appear low, you could end up paying more for a loan than you originally anticipated. Banks will often quote you the Annual Percentage Rate (APR). the trick part is to get a clear understanding or the word ‘Period’ or the frequency of compounding when looking at the APR.

As we learned earlier, this figure does not take into account any intra-year compounding either semi-annual (every six months), quarterly (every three months), or monthly (12 times per year) compounding of the loan. The APR is simply the periodic rate of interest multiplied by the number of periods in the year. To give you another example, let’s say you get a 5% loan from a bank that can have various compounding frequencies(monthly, quarterly, semi-annual). Take a closer look at the table below and you’ll see that what you will end up paying is very different than the rate bank quoted you. This table consider three rate quotes – 5%, 8%, 10%.

Your Effective Interest Rate | |||

APR | Monthly | Quarterly | Semi-Annually |

5% | 5.11% | 5.09% | 5.06% |

8% | 8.34% | 8.24% | 8.16 |

10% | 10.43% | 10.38% | 10.25% |

As you can see, higher the compounding frequency, higher the rate you’ll end up paying. Did you notice the last row where effective interest rate is almost half a percentage point higher than the rate quoted? Now think of an average home loan where you’re paying for next 30 years, and magic of APY is evident. Even a semi-annual compounding will make you pay thousands of dollars more over the life of your loan.

Now let’s consider the case where you’re the lender and bank is borrowing money(Saving accounts, CDs). As you can see most banks will quote you APY in this case since APY is higher than APR and you will be tempted to put your money where interest rate is higher. However, you should pay close attention to compounding frequency as well as other account fees before selecting an account based on APY alone.

Whether you are shopping for a loan or seeking the highest rate of return on a savings account or CD, be mindful of the different rates that a bank or institution quote. Depending on which side of the lending tree you stand banks and institutions have different motives for quoting different rates. Always ensure that you understand which rates they are quoting and then compare the equivalent rates between alternatives. Also, consider the length of time you’re going to deposit your funds with the bank. If length of time is fairly short(less than a year), you might want to consider offers with monthly or quarterly compounding.