I’m off to Greece! As you read this, I may very well be on a plane on the way to Chautauqua! While I’m globetrotting, enjoy a guest post that actually contains something useful. You don’t get a lot of that here on 1500 Days…
The Difference Between APR and APY
APR and APY can be easily confused. They have some similarities but also have some differences. APR stands for annual percentage rate and APY stands for annual percentage yield. I’m guessing that didn’t help you understand the difference though.
To understand the difference, let’s look at instances when each one is used. First we will look at APR. APR is used when talking about loan interest rates. When obtaining a loan, the borrower is offered an interest rate. This interest rate is called the base interest rate. Unfortunately for the borrower, the interest rate is not the only cost to borrowing money. The cost of borrowing also includes fees and charges such as an origination fee, brokers fee, and other closing costs. The APR uses these added costs to calculate a total rate of interest including all costs…not just the interest rate. The APR also accounts for the compound interest method that is used. The more the interest is compounded, the higher the calculated APR will be. Most loans are compounded monthly but loans like payday loans can be compounded as frequently as daily. When the cost of fees and compounding method are combined with the interest rate, a total interest rate cost is calculated called the APR.
Why is the APR important? Most people only look at the loan interest rate and choose the loan with the lowest interest rate. Other people will “buy points” upfront in order to get a lower interest rate. The truth is that the interest rate only tells part of the story (and it’s not the important part). What a borrower should be paying attention to is the annual percentage rate since the annual percentage rate is the interest rate that considers all costs of borrowing in order to calculate the actual rate of interest being charged. This is extremely important when comparing multiple loan or mortgage offers. It can also be important when comparing credit card offers. Credit cards are notorious for charging very high annual percentage rates. Knowing what APR means and how it should be used is imperative when choosing a credit card and saving money.
Let’s look at another example. What if your mortgage broker offers you a cut in the interest rate in exchange for a sum of money upfront. They call this “buying points.” But when your mortgage broker shows you the new APR, it is higher after buying points than it was before. Should you buy the points upfront then? The obvious answer is no because buying the points increased the APR. How could this happen? It happened because your mortgage broker was charging more money upfront, than the extra interest rate cost over the life of the loan.
Now let’s look at APY. APY is used to calculate the interest rate earned on fixed investments. Whereas APR is usually used to calculate an interest rate on loans. This includes time deposit accounts such as certificates of deposit, savings accounts, checking accounts, and money market funds. The amount of interest calculated in the APY rate depends on the method of compounding used. The higher the rate of compounding, the higher the APY will be. Most fixed deposit accounts compound monthly while others compound daily, quarterly, or annually. Which means the interest you’re earning will be higher the more often the interest compounds.
Can APY be used when calculating interest rates on loans? It can be used on loans too but it is primarily used to calculate interest rates when different compounding methods are used. This means if the loan doesn’t have additional fees, the APY calculation can be used. This makes APR and APY interchangeable when only considering the compounding method. But if loan fees must also be considered, then APR is the term that must be used.
The other similarity between APR and APY is that they are driven by market interest rates. People often ask what’s a good APR on a loan? Or what is a good APY on a savings account? These questions are dependent on the market and what’s being offered at that point and time. Today a good APR on a mortgage might be 5 percent but 10 years from now, a good APR may be 10 percent. The market changes and so the answer to this question changes.
In conclusion, APR and APY are different but they are similar. APR is more common to use for loans while APY or annual percentage rate is more common to use with fixed interest accounts. APR calculates an interest rate that factors in interest compounding and any loan fees. APY only calculates an interest rate using the interest compounding method. Both can be used for loans but APR calculates a more complete picture when loan fees and other charges exist.
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