If you try to compare rates on things like auto loans, credit cards, home loans, or savings accounts, you’ll quickly see APY (annual percentage yield) and APR (annual percentage rate) numbers quoted all over the place. In a nutshell, APY refers to what you can earn in interest while APR refers to what you can owe in interest charges.
APY refers to what you earn.
APY indicates the total amount of interest you earn on a deposit account, like a CD (certificate of deposit) or a savings account, over one year. Although it’s based on the interest rate, APY also takes into account the frequency of compounding interest to give you the most accurate idea of what you’ll earn in a year.
For example, if you found an account that offered 5.10 percent interest compounded annually and one that paid 5.0 percent interest compounded daily, figuring out which one really paid the most would require some serious math. (If you like serious math and want to know more about how APY is calculated, learn more here.)
If you don’t want to worry about all that, you can just compare APYs. It turns out that in the example above, the account that compounds daily has an APY of 5.12 percent. The one that compounds annually has an APY of 5.10 percent.
If you always compare APYs on deposit accounts, you can be sure you’re comparing apples to apples. Banks are required to display their APYs anyway. All you really need to know is that the higher the APY, the faster your balance grows.
APR refers to what you pay.
APR indicates the total amount of interest you pay on a loan account, like a credit card or an auto loan, over one year. APR is based on the interest rate, but for some loans, it also takes into account points, additional fees, and other associated loan costs.
It does not take into account the frequency of compounding interest, so you may have to read a little fine print to get the most accurate idea of what you’ll pay in interest over a year. That’s because you can’t tell just by looking at the APR how often the bank will compound that interest you’re accruing.
For example, let’s say you find a loan with an APR of 8.28 percent. Just from looking at the APR, you don’t know if you’re paying 8.28 percent applied to your balance once at the end of a year, or 0.69 percent (8.28 percent divided by 12 months) on your loan balance monthly. The more frequently the rate is applied to a balance, the higher the total amount you’ll pay.
The factors that go into calculating APR vary by loan types. Credit cards generally have several different APRs for different types of transactions, like one for cash advances and one for regular purchases. APRs for mortgage loans could include insurance and closing costs. To be sure you know what you’re really paying, ask exactly what’s included in the advertised APR for the loan you’re considering.
The variables can get complicated, but the takeaway for APR is this: the higher the APR offered for your loan account, the more interest you pay over a year on a given balance.
So what do APY and APR have to do with interest rates?
APY and APR represent a more holistic way to see what you will earn (or owe) versus just looking at the interest rate on the account. However, one thing you do want to keep an eye on when comparing is compound interest. Compound interest can have a significant impact on what you earn or owe. Remember, APY already takes into account compound interest, but APR does not.
Don’t overlook compound interest.
Compound interest means interest accrues on previously accrued interest and your initial principal. Compound interest can work for or against you, depending on whether you’re earning it or paying it, and how frequently it’s being compounded, whether it’s daily (like on Ally Bank deposit accounts), quarterly, or yearly. Either way, the method is the same: at a given frequency, interest gets added to the principal and begins affecting total interest earned or paid.
The example below shows how compound interest works on a deposit account that pays 3 percent interest compounded daily (rounded to the nearest dollar).
In this example, the amounts are small, but you get the idea. With larger deposits over a longer period of time, that compounding effect can really add up.
Remember, APY indicates the total amount of interest you could earn on an account in a year, taking into account frequency of compounding interest. APR, however, refers to what you owe, and does not reflect frequency of compounding interest. In that case, compound interest works the other way around. The interest on your debt can add up quickly, too, so it’s important to understand how it works.
Why not just compare interest rates?
While the interest rate is the major factor in calculating both APY and APR, it just doesn’t tell the whole story. When you’re shopping around for a savings account, for example, it’s best to compare APYs as you will get the most accurate view of your earning potential. Likewise, if you’re shopping around for a credit card, it’s best to compare APRs and fees to get the most accurate view of what you could owe.
You can think of the interest rate as a starting point for comparison as long as you keep in mind the various factors mentioned above that affect the real-dollar amount of interest you actually earn and pay.