Looking to borrow money or make an investment? Understanding APR and APY in banking will help you make the right decision for your personal or business finances.
If you’ve ever invested or used credit products, you’ve considered the interest and therefore encountered the terms APR and APY at some stage. So, what difference does one letter make? Well, it marks the difference in how these financial items impact your finances.
The APY vs. APR distinction delineates the most important types of accounts: Savings/investment accounts and lines of credit. Here’s everything you need to know.
APR vs. APY: The Definitions
As you know, both terms are acronyms. APR is an abbreviation for annual percentage rate, while APY stands for annual percentage yield. Both signify a type of interest, and understanding them requires understanding compound interest in general.
Compound interest is “interest you earn on interest.” For example, standard interest is calculated as follows:
Principal figure x Interest rate x Term of agreement (usually in months)
On the other hand, with compounding interest, you will pay or earn interest on this interest. Without worrying too much about the complex formula, the key outcome is that interest grows with every payment cycle.
What Is APR?
APR in banking represents a percentage of a loan principal you’ll pay in interest for a year. In other words, APR is a borrowing term, not a savings term.
The APR figure is achieved by multiplying the interest rate by the number of payment periods in the year. As a formula, this is expressed as:
APR = interest rate x number of annual payment cycles
Most financial products use a month-based payment cycle model. In the US, lenders are obligated to inform clients of the APR on any credit agreement, as per the 1968 Truth of Lending Act. APR includes the total borrowing costs over a year, so it should be the biggest deciding factor when considering a loan.
What Is APY?
APY in banking can relate to both borrowing and savings. In lending, APY represents the percentage of your principal you’ll pay, but with the compound interest taken into account. Although not as commonly used on borrowing, APY can be deemed more accurate than APR as it takes the compounding interest into account. Still, APY is rarely used when describing loans, and is primarily a term encountered with savings accounts. As a formula, this is expressed as:
APY = (1 + Periodic Rate) x Number of periods – 1
In other words, what APY is on a savings account, is essentially the total interest you’ll earn on a deposit account over one year, assuming that no deposits and withdrawals are made.
APR vs. APY: The Differences
Have you ever noticed that you’ve most commonly seen APY mentioned by investment companies and savings account summaries, while credit lenders tend to focus on APR? Once you see the two in practical examples, it becomes easy to see why.
If you were to borrow $1,000 with an APR of 6%, you would essentially be paying 0.5% interest per month (6% divided by 12). Each month, the interest would be $5, making for an annual interest total of $60.
Conversely, as per the APY definition in banking, the APY would mean you pay the same $5 in the first payment period. However, in the second month, you would pay 0.5% on the new balance of $1,005. And so on. Over the course of a year, it would mean paying 6.17% in interest. In this example, that’s only an extra $1.68. However, with bigger sums and a more realistic interest rate in mind, it’s easy to appreciate how it can impact every loan.
Consumers looking at credit cards, loans, and other forms of lending often prefer APR as it delivers a clear bottom-line figure. This makes it very easy to compare financial products from different lenders, but it conceals the compound interest.
When borrowing money, APY gives you a clearer understanding of what you’ll actually pay compared to the promoted APR. So, it may be the key to avoiding unexpected interest costs over the term of your agreement.
If you are an investor or lender, though, APY is the only thing you should be concerned with, as you won’t be paying interest – just collecting it.
APR vs. APY in Crypto
In addition to traditional financial products, APR and APY are two tools that are now used by lenders and investors in the crypto arena. They work the same as they do in fiat finances: APR is the interest a trader will pay on a crypto loan over the course of a year, while APY is important for investors, as it represents the return they can expect annually.
This is because it takes into account the fact that the initial investment is continually re-invested and gives you the compounding results. However, since crypto is extremely volatile, neither figure really tells borrowers or investors much about the future, as the same percentage could equate to wildly different figures in the span of just one year.
The Final Word On APR vs. APY
Both APR and APY are essential terms that relate to interest payments and may subsequently significantly influence your overall repayment obligations on borrowing accounts or the interest gained on investments and savings accounts.
With a deeper understanding of both terms, making a calculated decision regarding the best financial products for your situation should become a lot simpler – don’t shy away from using an APY calculator, either, as that will give you the most precise numbers you might fumble while doing maths by hand.