Annual percentage rate (APR) and annual percentage yield (APY) can be two confusing financial concepts, but understanding the difference can help you make better, more informed financial decisions.
In the APR vs. APY comparison, you should know that when people talk about saving money, they commonly use the term APR when referring to the periodic interest rate the bank pays you. That's actually not quite correct.
What is APR?
When someone talks about APR in relation to saving, what they really mean is the "periodic rate" or, simply "the rate."
We'll get back to that later, but it's important to note that APR is a term that applies to loans. It's the amount of money that the lender charges you for borrowing money, and it doesn't take into account how the interest is applied to your balance:
The periodic rate is simply the rate that's applied to your balance, when it's applied. To understand how APR works with loans, let's look at an example.
If your loan has an APR of 8.28% you might be paying a periodic rate of 8.28% applied to your balance once (at the end of one year) or it could mean a periodic rate of 0.69% applied to your loan balance monthly (8.28% divided by 12 months) — and that's precisely why understanding the APR vs. APY comparison is important.
APY can be either a lending term or a savings term, but in either case, APY takes into account how interest is applied. More importantly, if you're saving money, it tells you how much interest you'll be paid.
What is APY?
Before we go further, let's take a step back and look at a related concept: compound interest.
Let's say you deposited $1,000 in a 12-month CD, and your balance is $1,010 at maturity. Then, instead of withdrawing the $10 in interest earnings, you renew your CD for another 12 months under the same terms.
That $10 may not seem like a lot of money, but keeping it in the CD helps you earn more interest, and if you continue the same renewal cycle without making withdrawals over a period of years, your balance grows even faster because you earn more interest on the interest you've already earned. That, in a nutshell, is how compound interest works:
So let's look at how a periodic rate compounded yearly versus compounded monthly affects AP when the periodic rate (again, usually expressed as simply "rate") is 1.32%:
(1 + .0132)1 -1 = .0132 or 1.32% APY
If your initial deposit was $1,000 you'd have $1,013.20 after a year
(1 + 0.0011)365 -1 = .01329 or 1.329% APY
If your initial deposit was $1,000 you'd have $1,013.29 after a year
Maybe the extra 9 cents with an APY of 1.329% isn't a big deal, but why wouldn't you want to earn more if you could go with a bank that uses daily compounding? After all, when you look at larger amounts deposited for longer periods, that money adds up fast.
Incidentally, the interest on every Ally Bank CD is compounded daily to help you grow your balance faster.
It's just another example of how we're here to help you make informed financial choices. We don't show you "teaser rates" because we're committed to doing right by you and your money. Take a moment to explore your options and see for yourself. Visit AllyBank.com or call customer care at 888-247-ALLY (2559), where live help is always available.