What's The Difference Between APR vs. APY?
- The interest rate you'll pay on a loan is expressed as an annual percentage rate (APR).
- The amount of interest you make on your savings is measured by annual percentage yield (APY).
- You might pay less interest on your savings if the APR is lower. But conversely, you may earn more interest on savings if the APY is higher.
APR: What Is It?
Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are two common ways to express the interest rate on loans, investments, and other financial products. Although they may sound similar, they have different meanings.
The interest rate you will pay on a loan is expressed as an annual percentage. Credit cards, loans, and lines of credit are all financial products with an annual percentage rate attached. For example, if you borrow $1,000 for one year at an APR of 10%, you will owe $1,100 at the end of the year.
According to the Consumer Financial Protection Bureau, when compared to an interest rate, ¨the annual percentage rate is a broader measure of the cost of borrowing money than the interest rate.¨
The interest rate and additional expenses like closing costs, insurance, and lender fees can all be included in the APR. The APR and interest rate might be the same if lender fees aren't factored into it, which is frequently the case for credit cards.
When comparing certain credit offers, like those for auto financing, the APR may be more helpful than the interest rate because it can factor in costs like lender fees.
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Current market rates, interest rates, and credit ratings affect a good APR. You will pay less interest if the APR is lower.
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APY: What Is It?
The amount of interest you make on your savings is measured by annual percentage yield. Savings accounts, certificates of deposits (CD), and money markets are all associated with APY. For example, if you invest $1,000 in a savings account for one year with an APY of 10%, you will earn $100 at the end of the year.
APY rates fluctuate with the market and are subject to change after opening a new account.
The annual percentage yield shows how much interest your investment could earn in a year. In general, the higher the APY, the higher the potential return on your investment. However, how much you can earn is also determined by the amount of money in your account.
In addition to the interest rate, the annual percentage yield considers compound interest and how frequently compounding occurs in a year. Compound interest means you earn interest on the interest you've already earned in addition to the amount deposited.
When comparing deposit accounts, the APY can be more valuable than the interest rate because it takes compounding into account. A deposit account that earns more interest and compounds daily makes more money than an account with interest that compounds annually.
Unfortunately, the market determines what a good APY is. Generally, you earn more interest the higher the APY.
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The annual percentage rate relates to interest owed, while the annual percentage yield refers to interest earned. Though slightly different, both generally have fees attached.
Annual percentage yield is typically higher than the annual percentage rate because interest compounds more frequently when the difference between APR and APY is more significant.
While banks and other financial institutions want to make the cost of borrowing appear as low as possible with APR, they want to make the earnings on your savings appear as high as possible with APY. Therefore, making the financial product, whether it be a loan, credit card, or savings account, appear as appealing as possible to the potential customer is the main objective for both.
When looking around for financial products, it is worthwhile to read the fine print and learn more about these numbers because, despite their imperfections, both adequately determine overall interest compared to the standard interest rate.
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The Power of Compound Interest
Compound interest is the interest earned on an investment's principal as well as the accumulated interest. This means that the interest earned on investment grows exponentially over time.
Compound interest's strength lies in its ability to grow a small sum of money into a large sum over time. Even small, consistent contributions to an investment account can compound and grow significantly over time.
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Assume you put $1,000 in a savings account with a 5% annual interest rate. You would earn $50 in interest at the end of the first year, bringing your total to $1,050. You would earn interest not only on your original $1,000 but also on $50 in interest earned in the first and second years. So you'd have $1,100 by the end of year two.
The effects of compound interest become more pronounced over time when there are multiple compounding periods. For example, if you invested $10,000 for 30 years at an annual interest rate of 8%, your investment would grow to more than $100,000 thanks to the power of compounding.
Compound interest works in both directions, and debt can compound just as quickly as investments. This is why, to avoid compound interest's negative effects, pay off high-interest debt as soon as possible.
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Things You Should Know
Compound interest can be calculated daily, monthly, quarterly, or annually. With how often compounding occurs, frequent compounding may increase the earnings on your investment accounts while increasing the costs on your credit accounts.
Your rate is subject to change. If your rate is fixed, it is likely to stay the same. However, if it is variable, it is more likely to change. If you have an introductory APR, ensure you know how long it will last and what your rate will be once it expires. Also, remember that the APY for deposit accounts is typically variable and subject to market fluctuations.
You should be clear on which APR applies to you. Different types of transactions have different APRs on some credit accounts. For instance, credit card companies might have a different APR for cash advances or balance transfers than they do for purchases.
Make sure that you comprehend all of the terms and fees. Not all credit accounts have the same fees included in their APRs. Some may not have any fees. Deposit accounts may also have fees that are not reflected in the APY.
The Money Wrap-Up
The annual percentage rate is the nominal interest rate without considering the effect of compounding. In contrast, annual percentage yield is the effective interest rate taking into account compounding. You might pay less interest on your savings if the APR is low. But conversely, you may earn more interest on savings if the APY is higher. Comparing two investment options or loans is important to compare the APY instead of the APR to get an accurate picture of the actual return or cost.
Disclaimer: The information in this article should not be considered financial advice. Consult with a financial advisor before making any major decisions.
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