When it’s in the wrong place, like a name in an important legal document, one letter can have a big impact.
So it is in the world of interest rates, where the similar-sounding terms “APR” and “APY” mean very different things. If you have a credit card and a bank account, you’ve already encountered both. If you’re just setting out on your personal financial journey, you’ll run into them soon enough.
When you do, you’ll need to understand what sets them apart.
APR vs. APY
APR (annual percentage rate) measures the interest rate you pay on loans and other credit products. APY (annual percentage yield) is the interest rate you earn on balances in interest-paying deposit accounts, like savings accounts.
But that’s not the only way they’re different. APR and APY differ at the highest levels.
Lines of credit
Other interest-bearing accounts
|Includes Compound Interest
|Includes Loan Fees
Beyond the slight naming variation, APR and APY differ in key ways:
- Who earns and pays interest. APR describes interest paid by the consumer, while APY describes interest earned by the consumer.
- Compounding. APY includes compound interest, the interest that accrues on interest. APR doesn’t.
- Loan fees. APR often includes fees that can raise total borrowing costs, like origination fees. However, it doesn’t always include all fees; for example, credit card APRs don’t account for annual account fees or late fees.
Both share similarities as well. For example, APY is always higher than the stated interest rate on the account due to the beneficial effects of compounding. On installment loans, APR is higher than the stated interest rate as well because it includes loan fees not reflected in the simple rate.
Annual Percentage Rate
APR measures the total annual borrowing cost on a credit product, including fees. It’s expressed as a percentage rather than a dollar amount.
APR is a useful tool for comparing loans and credit cards. Though it doesn’t directly show the actual amount of interest and fees you’ll pay over the life of the loan, it clearly shows whether a particular loan is more or less expensive than the loan or loans you’re comparing it against.
Financial Products That Use APR
APR measures credit products’ interest rates. Any financial product that charges interest to a borrower can use APR, such as:
- Credit cards
- Other unsecured lines of credit
- Secured lines of credit, like home equity lines
- Unsecured personal loans
- Student loans
- Car loans
- Mortgage loans (purchase and refinance)
- Home equity loans
- Business loans and lines of credit
The formula to calculate APR is basic arithmetic, but probably not the kind you can do in your head. The formula is:
(Interest + Fees) ÷Principal
Days in the Loan Term
Grab your calculator and follow along:
- Find the total interest charged over the life of the loan. For most loans, you can find this in the loan disclosure documents the lender provides when you apply.
- Add any fees charged by the lender and bundled into the total loan amount.
- Divide the combined total by the loan principal.
- Divide the result by the total number of days in the loan term. A year has 365 days, so a 36-month loan has a term of 1,095 days.
- Multiply the result by 365. This is the decimal APR, also known as raw APR.
- Multiply the result by 100. This converts the raw APR into a percentage, which is the customary way to express APR.
Variable APR Calculation
If your loan or credit line has a variable interest rate, the APR changes every time the underlying interest rate changes. That means you need to recalculate APR each time your rate adjusts.
If the rate adjusts on a predictable schedule, which is generally the case with adjustable-rate mortgages, set the number of days compounding as the number of days between adjustments. For example, if your rate adjusts yearly, you’d use 365 for each year’s calculation.
Credit Card APR Calculations
If you’re calculating the APR on a credit card, set the fees to 0. Credit card APRs don’t include fees because they’re charged separately and not added to the loan balance, unlike origination fees and other installment loan surcharges.
Annual Percentage Yield
APY measures the total amount of interest earned on balances in interest-paying accounts, like savings accounts and certificates of deposit. It’s expressed as a percentage rather than a dollar amount.
APY makes it easy to compare deposit accounts that pay interest. The higher the APY, the more generous the account.
APY calculations account for compound interest, or interest on interest. The compounding frequency tells you how often the interest you earn is added to your principal balance, where it begins to earn interest. The higher the compounding frequency, the higher the APY and the wider the gap between the base interest rate and the APY.
Financial Products That Use APY
Every interest-paying deposit account uses APY to show the true rate at which account holders earn interest, after taking compounding into account. So do other financial products that pay interest. Examples include:
[(Decimal Interest Rate÷Number of Times Compounded+1)^Number of Times Compounded]
You need a calculator for this one too.
- Convert the simple interest rate into a decimal (move the decimal to the left twice) and divide that by the number of compounding periods per year. For example, if your interest is compounded daily for one year, the number of compounding periods is 365.
- Add 1 to the result. That just gives you a number greater than 1, making the equation easier to understand as you go along.
- Multiply the result by the same number of compounding periods you used the first time.
- Subtract 1 from the result to get the raw APY (expressed as a decimal that’s less than 1).
- Multiply by 100 to get the percentage APY.
Variable APY Calculation
Many interest-paying financial products have variable interest rates that change with prevailing benchmark rates, like the federal funds rate. Each time the base interest rate changes, the APY changes as well. To find the new APY, simply change the simple interest rate and run the calculation again.
Bottom Line: Compound Interest Is the Key Difference
It bears repeating that compound interest is the biggest difference in APR and APY calculations. The APY formula accounts for compound interest, while the APR formula doesn’t.
This doesn’t mean that the APR formula is somehow incomplete. Installment loans generally charge simple interest. That means you only pay interest on the principal, which declines with each payment. Your interest charges aren’t added back to the principal, and because you’re (hopefully) making steady payments that reduce the principal, those interest charges make up a decreasing share of each payment. Your final payment is almost entirely principal.
Even personal finance experts get tripped up by the distinction between APR and APY. Who knew one letter could make such a difference?
To remind myself, I ask which direction the money flows. If it’s a consumer getting paid, they’re earning APY. If it’s a lender getting paid, they’re raking in APR.
Knowing who benefits also helps if and when you use APR and APY to compare financial products. The higher the number, the better it is for the party getting paid, and the worse it is for the party on the other side of the transaction. As a consumer, you want to keep your APRs low and your APYs high.