For a lot of people, hearing that their financial future can depend on the mathematical distinction between their annual percentage rate (APR) and their annual percentage yield (APY) seems like some kind of dystopian nightmare, and understandably so. However, if you're one of them, not to worry, that's why we're here. Let's dig into this topic and simplify it as much as possible so that banks and lenders can no longer use it against you.
What Is APR?
APR stands for annual percentage rate which is basically just the yearly rate of interest applied to earning money or borrowing it. So, if you borrow $1,000, and they charge you a 1% interest rate every month then your annual percentage rate is 12% because you're being charged 1% 12 times a year. Simple enough so far right?
What Is APY?
APY stands for annual percentage yield which is the yearly interest when you factor in compounding. Simply put, compounding describes the process of earning interest on previously earned interest. It sounds confusing, I know, but it will get much clearer once we apply the concept to the real world, I promise.
As we said earlier, APR is the interest per time period multiplied by the number of periods per year. In our previous example, we had an APR of 12% because 1% interest was applied 12 times every year, right? Here's where the lenders get sneaky. They are only required to tell you that the APR is 12% but that doesn't tell you whether that's 1% every month or 3% every quarter. It may seem like a semantic difference but it really isn't once you consider compounding. So, if you deposit $10,000 into a savings account with an APR of 5% compounded yearly, then after 1 year, you'll have earned $500 in interest because $10,000 times 0.05 (or 5%) is $500.
If it's compounded monthly, however, then the APR of 5% would be divided by 12, one every month, which would make the interest 0.42%. This way, you'll now have $42 of earned interest after one month because $10,000 times .42% interest is $42. The difference is, now that you're applying interest to the amount every month, when you start the calculations for next month, you'll begin with $10,042 to add interest to.
The more times its compounded, the higher the amount you start with before multiplying, which means the higher the outcome. In this particular case, you'd then have earned almost $12 extra by the end of the same 1 year. If you keep going over multiple years, it really starts to add up!
How They Use It Against You
When you take out a loan, they want to give you the APR because that number doesn't provide all the information. When you are earning interest, they use APY to make the interest amount seem higher, which it is. Knowing the difference can save you thousands or more over the course of your life.
Now that you understand the difference between APR and APY you're better equipped to make good financial decisions. Next time you're taking out a loan or getting a credit card and the lender gives you the APR you know to ask how often it's compounded or what the APY is. You'll finally have the upper hand.