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.
When you compare APR vs. APY, 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." 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:
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 APR vs. APY is important.
What Is APY?
APY, or annual percentage yield, is a term that applies to deposit accounts. APY is a percentage rate reflecting the total amount of interest paid on an account, based on the interest rate and the frequency of compounding for a 365-day period. 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 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 APY when the periodic rate (again, usually expressed as "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
In this example, the extra 9 cents with an APY of 1.32% doesn’t look like a lot, but why wouldn't you want to earn more if you could with a bank that uses daily compounding? After all, when you’re dealing with larger amounts deposited for longer periods, that money adds up.
At Ally Bank, we compound interest daily to help you balance grow faster. Learn more at Allybank.com or call live, 24/7 customer care at 877-247-ALLY (2559) today.