APR vs. APY For Beginners

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One of the top reasons people struggle is that they purchase financial products that they don’t understand.

The truth is if you want to be successful with money, you must know the basics — especially when it comes to concepts like annual percentage rate (APR) and annual percentage yield (APY).

Keep reading to learn about the differences between APRs and APYs and understand the impact they have on your personal finances.

Annual Percentage Rate (APR)

What is APR?

APR is a figure that indicates the true measure or cost of borrowing on a loan amount or a line of credit. It’s applied to credit cards, personal bank loans, auto loans, and mortgages. For example, a credit card may come with an APR of 15%, which represents the actual rate of interest you’ll incur on balances that carry over month to month.

APR is calculated using the average daily balance, which involves multiplying the mean outstanding bill balance at the end of the day to the daily periodic rate (DPR), as well as the number of annual periods.

APR = Periodic Rate x Number of Annual Periods

Let’s take a look at an example.

Suppose your credit card’s APR is 15%. This means you will pay a 15% fee, annually, for each $1,000 that you borrow. If you have a $10,000 balance on the card, you’ll rack up at least $1,500 in interest fees within the year.

APR for Credit Cards and Personal Loans

Borrowers sometimes confuse an APR as the annual interest rate on a loan or line of credit. However, APR can also incorporate extra fees that the borrower is expected to pay over the course of the loan (e.g., including a portion of the origination fee).

The easiest way to determine a credit card’s APR is to use a free online credit card APR calculator. Such tools will usually allow you to input the total balance, the expected monthly payment, and the interest to determine the overall payoff time.

How Grace Periods Work

Credit card companies sometimes offer grace periods with 0% APR as an incentive to get customers to sign up for certain services.

During a grace period with 0% APR, the customer will not be charged interest as long as they pay the balance in full by the expected due date. In these scenarios, the first due day can stretch out as long as 12 or 18 months.

Far-off credit card due dates may seem enticing, and in fact, they can be very useful. Oftentimes, borrowers will roll several payments into one card with a promotional rate to consolidate their payments and avoid paying interest. However, this plan can backfire if you don’t pay off the card in full by the time the grace period ends.

Rack up a high credit card bill and fail to pay it off on time, and you’ll be shocked at the amount of interest you’ll be on the hook for each month once the grace period expires and is replaced by a higher-than-expected rate.

APR for Mortgages

Financial institutions are notorious for adding extra fees into mortgage APRs on top of interest rates, like transaction, broker, mortgage, application and processing, and legal fees, among others.

So, when shopping for a mortgage, it’s vital to break down the monthly payment and understand the interest rate in addition to what you will be paying on a regular basis. The APR is usually higher than the interest rate in a mortgage payment.

You’ll be able to find the APR in all its detail on the loan estimate document the lender provides. One thing to keep in mind is that lenders do not have to include all fees in their APR calculations.

As such, borrowers are highly encouraged to clarify APRs with the lender before agreeing to the mortgage. That way, they can have a clear understanding of what they are signing up for.

Fixed vs. Variable APR

Another important point to note is that APRs can be either variable or fixed.

When you agree to a fixed loan, the interest rate will not fluctuate over the course of the loan. In other words, the rate you agree to pay will be the same throughout the course of the term. If you sign up for a variable APR, the interest rate will change from time to time.

Fixed APRs are typically more common amongst borrowers because the monthly payments will not change — even if current rates increase.

On the other hand, variable APRs can fluctuate based on current interest rates.  If rates increase, your monthly payments will eventually increase and if rates decrease, your monthly payments might go down. However, due to the uncertainty of the interest rate markets, opting for a fixed rate is generally considered the safer option.

APR Tips for Borrowers

1. Spend Within Your Means

If you are considering borrowing money or applying for a credit card from a company like American Express or Discover, make sure to stick with a budget.

Overspending on your credit card is an easy way to rack up a lot of debt, which can be extremely difficult to pay down.

2. Always Pay Your Credit Card Balance in Full

One of the easiest ways to avoid paying high-interest charges for credit cards is to always pay your balance in full — even if you have to pull money from a savings account or investment to do it.

Truth be told, this can hurt. But it definitely beats having to pay heavy interest.

3. Shop Around for Low Interest Rates

Before you agree to a credit card or loan, make sure to test the market for the lowest possible interest rate. Just keep in mind that whenever you apply for a credit card, the lender will perform a hard inquiry that will adversely impact your credit score.

Consider running a credit check ahead of time and doing your own research to avoid continuously applying for cards. Hard inquiries lower your credit score. And when you have a low credit score, it can be difficult to get a mortgage or get a good price on a car loan.

Annual Percentage Yield (APY)

What is APY?

APY refers to the amount that a bank account will earn in interest over the course of a year. In short, an APY will give you an estimate of your expected return based on the interest rate offered by the bank and your initial deposit.

It gets a little technical, but APY is calculated as follows:

APY = (1 + r/n )^n – 1

r (interest rate)

n (number compounding periods, annually)

How APY Works

APY can be applied to a few different types of accounts.

For example, an APY can be applied to checking accounts, traditional savings accounts, high-yield savings accounts (HYSAs), money market accounts, and certificates of deposit (CDs).

How Compounding is Applied

APY works by applying compounding interest.

In other words, interest accrues at specific intervals and is applied to the balance of the account. As time goes on and more interest is applied, the account balance gets bigger.

Using Ally’s example, here’s a look at how much APY you can earn over the course of one year on a $25,000 starting deposit.

APY Annual Interest Earned Account Balance
0.1% APY $2.50 $25,002.50 (yawn!)
0.03% APY $7.50 $25,007.50 (meh)
1.45% APY $362.50 $25,365.50 (boo yah!)

 

APY Tips for Investors

1. Watch Your APY on Variable Accounts

Putting your money into a high-yield savings account with a strong APY is a great way to maximize compound interest.

However, variable APYs can swing from time to time depending on the state of the economy and how the Federal Reserve acts.

Keep a close watch on how the economy is doing and check in from time to time to make sure that you are getting the best possible APY. If your interest rates drop, it may be a good idea to move money around strategically (e.g., into IRAs or other investment products). Or you can ride out a downturn and wait for interest rates to improve. It’s your call.

2. Think Twice Before Locking Your Money

Generally speaking, if you “lock” your money into an account like a certificate of deposit (CD) for a fixed period of time, you’ll earn more in interest.

However, this can also come back to bite you in the backside due to early withdrawal penalties. Instead, it can be more beneficial to maintain liquidity and have the option to move money around and shop for the best interest rates. It all depends on your specific scenario and how quickly you’ll need to access your savings.

3. Try Not to Touch Your Savings

It can be tempting to take money out of your savings account to pay for monthly expenses like rent, food, and entertainment. However, if you take money out of an interest-bearing account, it will impact your APY. Not only will you lose money by spending it, but you will also get a lower interest return at the end of the month.

For the best results, try to keep growing the total amount in your savings account. And if you take money out, put it back in and pay yourself interest.

APR’s Simple Interest vs. APY’s Compound Interest

It’s important to note the difference between simple and compound interest as it relates to APR and APY, respectively.

An APR’s simple interest is based on the principal amount of a loan. A simple interest APR refers to the interest amount that you owe for borrowing money.

On the other hand, APY’s compound interest is money that you’re earning, and it’s a key to building long-term financial wealth.

Compound interest means that your deposits accrue interest, and then interest is also earned on the accrued amount (your deposits, plus ongoing earned-interest).

In other words, compounding means interest on interest. Financial providers often use APY for products such as high-interest savings accounts and CDs, because APY indicates a higher rate.

The more frequently the compounding occurs, the higher the APY will be.

When comparing financial offerings, make sure to note the difference between APR and APY to avoid confusion.

Frequently Asked Questions

Is an APR or APY Better?

The answer to this question depends entirely on whether you’re borrowing money or earning interest.

Lenders typically advertise credit cards and mortgage rates in terms of APR because that rate is calculated from the simple interest — which results in a lower percentage.

Conversely, savings accounts, money market accounts, and certificates of deposit are advertised in terms of APY since the compound interest results in a higher percentage.

It’s not a question of whether one is better than the other, but it’s important to note that a financial institution will always present the most attractive rate to its potential customer.

How does simple interest work?

For a simple loan, interest is calculated based on the original amount of a loan. Compound interest is calculated on the principal amount in addition to interest that’s accumulated from previous periods.

One of the most common types of simple interest is student loans.

What does member FDIC mean?

Almost all banks are insured by the Federal Deposit Insurance Corporation (FDIC) while credit unions are insured by the National Credit Union Administration (NCUA). So, if you see that a bank says it’s a member of the FDIC, up to $250,000 in deposits is insured by the federal government.

How do lenders distribute mortgage fees?

When you sign up for a mortgage on a house, you will be hit with a variety of expensive fees. In some cases, you can choose to pay these fees over the course of a 15- or 30-year mortgage.

The tradeoff is that you can avoid putting more money down on your initial investment, meaning you’ll have more cash on hand to cover some of the numerous expenses that will come with homeownership. However, paying these fees over time will increase your total APR.

The Bottom Line

APRs and APYs are critical financial metrics that can make or break a loan or borrowing decision. As such, borrowers and investors need to scour the fine print before agreeing to any deal to avoid complications.

If you have trouble understanding financial jargon, consider running deals through a trusted financial planner before agreeing to anything. There is no harm in asking a certified financial professional to break down an investment or borrowing decision and put it into layman’s terms that you can understand.

Another thing to remember is that—while a financial advisor can provide helpful advice—ultimately it’s on you as the borrower to make responsible payment decisions throughout the course of a loan or credit agreement.

As for APYs, it pays to shop around for deals that will provide maximum flexibility and ROI. Always scour the market to find the best rates and avoid agreeing to anything before understanding all of your options. If you develop a system and stick to it, you’ll make the right decisions.

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