APR vs. APY: What You Need to Know

In order to be an effective consumer, you need to be familiar with terms related to borrowing and saving. Two such terms are annual percentage rate (APR) and annual percentage yield (APY), which you will see any time you open a bank account or get a loan. Although these terms sound very much alike, not knowing the difference between the two can be very expensive.

Both APR and APY refer to the amount of interest paid on a principal amount of money. This is either the interest you pay on top of a loan that you take out or the interest that someone pays you in return for your investment. The essential difference between APR and APY is compounding interest. Compounding interest is when interest is paid for the principal amount of money and the accumulated interest. When interest is compounded, the amount of money you have can grow very quickly if the interest is being paid to you. If you are paying interest, then the compounding means that you will have more to pay. APY accounts for compounding interest, but APR does not.

If you take out a loan or make an investment that will compound interest, you should calculate the APY. To do so, use the following formula:

APY = (1+ Periodic Interest Rate)^{number of periods in a year} - 1

If you see a bank or credit card application advertising its current APR, it means they are quoting you the rate that does not account for compounding interest (this is sometimes known as simple interest). APR is simply the percentage of interest to be paid on a loan or investment annually. APR tends to be a lower percentage amount than APY. To calculate APR, use the following formula:

APR= Periodic Rate x Number of Periods in a Year

Financial institutions sometimes promote one rate rather than another in order to persuade consumers that their rate is better than their competitors’ rates. For example, credit card companies often promote their APR because it is lower than the APY, which makes it seem like customers will pay less interest. Investment firms, on the other hand, prefer to advertise their APY, which shows that customers' investments will earn more interest. To avoid being fooled by a financial institution using a more attractive rate, consumers should pay close attention to whether they quoted APR or APY. Those borrowing money or using credit cards should focus on the APY because it will prepare you for the higher interest payment. When saving or investing money, however, you need to see the APR because it prepares you for a more conservative return.

READERS, what do you think?

Do you think many people confuse APR and APY? Why or why not?

Reference:

Investopedia US. (2010, February 7). APR and APY: Why your bank hopes you can't tell the difference. Retrieved from http://www.investopedia.com/articles/basics/04/102904.asp#axzz2JEgjDq4l.

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