When it comes to loans, credit cards, and savings accounts, you’ll often encounter the terms APR (Annual Percentage Rate) and APY (Annual Percentage Yield). While they might seem similar, they are different ways of measuring interest. Understanding the difference can help you make smarter financial decisions, whether you are borrowing money or investing it.
What Is APR?
APR stands for Annual Percentage Rate. It represents the yearly cost of borrowing money, including interest and certain fees, but it does not account for compounding within the year.
- Use Cases: Loans, mortgages, credit cards
- Purpose: Helps borrowers understand the true cost of borrowing
- Includes: Interest rate + certain fees
Example:
A loan with a nominal interest rate of 6% and $100 in fees for the year may have an APR of 6.2%.
Key Point: APR gives a standardized way to compare loans, even if they have different fee structures.
What Is APY?
APY stands for Annual Percentage Yield. It measures the real rate of return on an investment or savings account after accounting for compounding—how often the interest is added to the principal.
- Use Cases: Savings accounts, CDs, money market accounts
- Purpose: Shows how much you will actually earn in a year
- Includes: Interest rate + effect of compounding
Example:
A savings account with a 5% interest rate compounded monthly has an APY of about 5.12%.
Key Point: APY is always equal to or higher than the nominal interest rate if there is compounding.
Difference Between APR and APY
| Feature | APR | APY |
|---|---|---|
| Full Form | Annual Percentage Rate | Annual Percentage Yield |
| Focus | Cost of borrowing | Earnings on deposits |
| Compounding | Not included | Included |
| Typical Use | Loans, credit cards | Savings, CDs, investments |
| Shows | Total yearly cost | Total yearly earnings |
Why APR and APY Matter
For Borrowers
Understanding APR helps you:
- Compare loan offers accurately
- Account for fees beyond just the interest rate
- Avoid costly surprises when paying off loans
Example: Two loans with 5% nominal rates but different fees:
- Loan A: APR 5.1%
- Loan B: APR 5.5%
Loan A is cheaper overall.
For Savers
Understanding APY helps you:
- Know how much your money will grow
- Compare savings accounts with different compounding frequencies
- Choose accounts with higher effective returns
Example:
- Bank A: 5% interest, compounded annually → APY 5%
- Bank B: 5% interest, compounded monthly → APY 5.12%
Even though the nominal rate is the same, Bank B pays more due to compounding.
How Compounding Affects APY
Compounding increases earnings by adding interest to the principal over time. The more frequently interest compounds, the higher the APY.
| Compounding Frequency | Nominal Rate | APY |
|---|---|---|
| Annually | 5% | 5% |
| Quarterly | 5% | 5.094% |
| Monthly | 5% | 5.116% |
| Daily | 5% | 5.127% |
Tip: Look for accounts with daily or monthly compounding to maximize returns.
Practical Tips
- When borrowing: Focus on APR to know the real cost of loans.
- When saving or investing: Focus on APY to know the real growth of your money.
- Compare like with like: Don’t compare an APR of a loan with the APY of a savings account—they serve different purposes.
- Check fees: Some loans with low APRs might have high fees, so always read the fine print.
- Compound frequency matters: Higher frequency increases APY even if the nominal rate is the same.
FAQs
Is APR always lower than APY?
Not necessarily—they measure different things. APR shows cost of borrowing without compounding, while APY shows earnings with compounding. They are not directly comparable.
Can APY be used for loans?
No, APY is for deposit accounts or investments. Loans use APR to indicate borrowing cost.
Why do banks advertise APY instead of interest rate?
Because APY shows the real earnings including compounding, making the account appear more attractive.
How can I calculate APY from interest rate?
APY=(1+nr)n−1
Where r = nominal interest rate, n = number of compounding periods per year.
Does APR include all fees?
APR includes most mandatory fees but may not include optional charges. Always check loan disclosures.
Key Takeaways
- APR = Cost of borrowing (does not include compounding)
- APY = Earnings on deposits (includes compounding)
- Use APR for loans and APY for savings
- Compare offers using the correct metric for accurate decision-making