The intention of this article is to help you understand the important difference between annual percentage rate (APR) and annual percentage yield (APY). These terms are applied to loans and investment products, but they are not equal and they significantly impact how much interest you earn or pay. In the APR vs. APY discussion, it is important to mention the term compounding. This is because financial institutions will quote interest rates that use compounding to their advantage. Simply, compounding here refers to earning interest on previous interest. we will talk more about compounding and its importance later. First, let’s define APR and APY
Annual percentage rate (APR) is the annual rate of interest charged for borrowing not taking into account the compounding of interest. APR represents the yearly cost of funds over the term of a loan. It’s expressed as a percentage and represents the actual yearly cost of funds over the term of a loan. APR includes any fees or additional costs associated with the transaction. Loans can vary in terms of interest rate structure, transaction fees, and other factors, and a standardized computation such as the APR provides you with a bottom-line number they can be used to compare rates charged by other potential lenders. For example, a credit card company might charge 2% interest each month; therefore, the APR would equal 24% (2% x 12 months = 24%). By law, lenders must show customers the APR so that there is a clear understanding of the actual rates applicable to their agreements. The lenders are allowed to advertise interest rates on a monthly basis e.g. 2% per month, but are also required to clearly state the APR to customers before any agreement is signed
Annual percentage yield (APY) is the effective annual rate of return taking into account the effect of compounding interest. It is the representation of an interest rate, based on a compounding period of one year. Much like the APR, the APY allows for a reasonable, single-point comparison of different offerings with varying compounding schedules. However, it does not account for the possibility of account fees and additional cost affecting the net gain. Additionally, APY generally refers to the rate paid to a depositor by a financial institution. To promote financial products, banks and financial institutions will often quote the APY as opposed to the APR because the APY represents the customer receiving a higher return. For example, a CD that has a 4.65 percent APR, compounded monthly, for 8-months would instead be quoted as a 4.75 percent APY. For financial institutions in the United States, the calculation of the APY and the related annual percentage yield earned are regulated by the FDIC Truth in Savings Act of 1991. Accordingly, the act defines APY as — the total amount of interest that would be received on a $100 deposit, based on the annual rate of simple interest and the frequency of compounding for a 365-day period, expressed as a percentage calculated by a method which shall be prescribed by the Board in regulations.
As a borrower of funds, you should always be searching for the lowest possible interest rate. When looking at the difference between APR and APY, you need keep in mind that a loan may be disguised. Banks will often quote you the APR as opposed to APY. As stated earlier, APR does not take into account any form of compounding. Again, the APR is simply the periodic rate of interest multiplied by the number of periods in the year. This illustrates two points. First, the importance of asking a potential lender or researching what rate he is quoting to you. Second, when seeking a loan, you can use the APR or APY to compare loans and make the most informed decision.
Banks and other institutions will often entice individuals by quoting APY. Just as those who are seeking loans want to pay the lowest possible rates of interest, those same individual wants to receive the highest rate of interest when they themselves are the lender. For example, when shopping to open a savings account, you are obviously seeking the highest rate of interest. In the banks best interest, they will quote APY as opposed to APR because there is some compounding during the year and the APY will be a higher number than APR. Whether you are shopping for a loan or seeking the highest rate of return on a savings account, be mindful of the different rates that a bank or institution quotes. Depending on which side of the lending tree you stand on, banks and institutions have different motives for quoting different rates. Always ensure you understand which rates they are quoting and then compare the equivalent rates between alternatives. It is important for the individual to understand the distinction between these two rates, because they can significantly affect that amount of interest that you pay or accumulate.