Despite having similar names, APR and APY are not the same.
It’s understandable that some individuals could conflate the words APR and APY. Both are employed in the computation of interest for credit and investment goods. Also, when they are applied to your account balances, they have a big impact on how much you earn or must pay.
Yet, despite the fact that APR and APY may sound similar, they are really distinct and not interchangeable. In contrast to APR, which stands for annual percentage rate, APY, or annual percentage yield, considers compound interest.
Understanding Compound Interest
Compound interest is allegedly the human race’s greatest invention, according to Albert Einstein.
Whether you agree or disagree, it’s critical to comprehend how loans and investments are affected by compound interest.
Compounding, at its most basic level, is when interest is earned or paid on prior interest and added to the principal amount of a deposit or loan.
Compound interest rates are used to compute interest on the majority of loans and investments. All investors aim to minimize compounding on their loans while maximizing it on their investments. Simple interest, in contrast to compound interest, is the consequence of dividing the number of days between payments by the daily interest rate.
APR
Since it appears that consumers would ultimately pay less for accounts like loans, mortgages, and credit cards in the long run, financial institutions frequently use APR to promote their credit products.
The compounding of interest over the course of a year is not taken into account by APR. The periodic interest rate is multiplied by the number of periods in a year for which the periodic rate is applicable to arrive at the calculation. The number of times the rate is applied to the amount is not stated.
Here is how the APR is calculated:
APR = Periodic Rate x Number of Periods in a Year
APY
Because it appears that investors will earn more on things like certificates of deposit (CDs), individual retirement accounts (IRAs), and savings accounts, investment providers typically advertise the APY they offer to attract customers. Contrary to APR, APY considers the frequency of interest payments—the impacts of intra-year compounding. For investors and debtors alike, this seemingly insignificant variation may have significant ramifications. The periodic rate is multiplied by the number of times equivalent to the number of periods for which the rate is applied, divided by 1, and then one is subtracted to get the annual percentage yield, or APY.
Here’s how APY is calculated:
APY = (1 + Periodic Rate)Number of periods – 1
APR vs. APY Example
A credit card company might charge 1% interest each month. Therefore, the APR equals 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest.
The APY for a 1% rate of interest compounded monthly would be 12.68% [(1 + 0.01)^12 – 1 = 12.68%] a year. If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 12%. However, if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of compounding each month.
