Annual percentage rate (APR) and annual percentage yield (APY) can be two complicating concepts, but understanding the differences can help you make any financial decisions. Both APR and APY are commonly used to reflect the interest rate paid on a loan or savings, money market or certificate of deposit. Let’s learn more about APR and APY in order to understand how these terms work so you know what you’re getting into.
How APR Works
An APR is basically the amount of interest you’ll be paying on a loan. The interest rate is a flat percentage of what you’ve gained that year. It will not include any compounding periods on your account or loan. Keep in mind, when you handle mortgage, the APR will have additional fees with the loans. This happens depending on the amount of money the lender charges you for borrowing it. However, it won’t take how the interest will be put onto your balance. To calculate APR:
APR = periodic rate x the number of periods in a year.
For example, a credit card company might charge 1% interest each month; therefore, the APR would equal 12% (1% x 12 months = 12%). But, don’t confuse interest rates and APR being the same thing. APR is a more efficient rate to use when you compare loans with one another. While it doesn’t charge you for the interest itself, it’ll charge you on other fees.
These fees will be the other charges that was involved in getting your loan. In other words, it can be like broker fees, closing charges, rebates, and discount points. Majority of the time they’re expressed as a percentage. Typically, the APR will always be equal to or more than the interest rate. The only time that doesn’t apply is when there’s a special deal where a lender gives a rebate for just a part of the interest rather than the whole thing.
What’s an APY?
Annual Percentage Yield (APY) is the banking term that’s used for deposit accounts. It’s a percentage rate showing the amount of interest paid on your account. This is based off of the interest rate and how frequent the compounding period is. Additionally, when you use APY, it will use the interest rate and see how much the interest is compounded over one year to see a percentage rate.
Normally, most banks keep an eye out for clients that have interest-bearing investments. This is for their best interest to talk about the APY rather than the APR. Plus, an APY is higher than the APR and has better investments for the consumer. To calculate your APY:
APY = (1 + Periodic Rate as a decimal) The Number of Periods in a year – 1
For example: The APY for a 2% rate of interest compounded monthly would be 26.82% [(1 + 0.02)^12 – 1= 26.82%] a year. Typically, the more frequent your interest compounds, the more money you’ll gain. With APY, it will include interest rate and the compounding time period for the expected percentage rate.
Now, lots of banks will offer their clientele weekly, quarterly, or monthly compounding periods. This will enable your interest to increase more rather than earning interest yearly. But, majority of the time it will be monthly rather than quarterly unless to pick otherwise. There are two types of ways that interest can be compounded and how often it happens. I’ll go over them below.
Simple Interest
Simple interest is one way your interest rates can be compounded. With this, what you gain will be off of the principal investments you make. Hypothetically, if you put $1,000 into an account that pays 5% interest annually, you’ll get $50 in interest at the end of the year. The next year you’ll also receive another $50 in interest rates.
Normally, you won’t have interest paid to you in cash after every year. Now, you’ll be able to build your interest up in your account with your original direct deposit. Take advantage of this fact and you’ll be able to see that this will benefit you quite well.
Compound Interest
When you compound interest, it will mean that the interest you’ve already made will be included with your original balance. Then, the new balance will be used to determine the next interest bill. You’ll be able to earn interest on your original investment and on the interest in itself.
However, this will all depend on what kind of account you have and the bank/credit union you’re with. Like the simple interest, it can be compounded daily, quarterly, or monthly (daily is less common).
The example provided earlier is a good reference as well. When you earn interest, you’ll be able to increase your savings and retire when you want to. There are lots of different ways to take advantage of your interest as well. Accounts such as: Certificate of Deposit (CD), Money Market, High-Yield Savings, and High-Yield Checking accounts, are great ways to earn interest.
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Conclusion
Now that you know the difference between what an APR and APY are, you’ll be able to determine which one would benefit you most. An APY will tell you how much you can earn in interest accumulated over the year.
Meanwhile, an APR will show you the amount of interest you’ll be paying for annually on a loan or revolving credit. Furthermore, when you sign up for an account or compare loans, be sure that you know which one will work best for you before applying.
