If you’ve ever applied for financing or opened a savings account, you’ve probably seen the terms Annual Percentage Rate (APR) and Annual Percentage Yield (APY). So, what do they mean? And how do they differ from one another?
Put simply, APR communicates the cost of borrowing money, while APY expresses the amount of interest you can earn on your savings. While both terms relate to interest, APR and APY have some important distinctions.
In this article, we’ll break down the differences between APR and APY so you can shop around for the very best rates.
What Is APR?
When you borrow money using a loan, credit card, or line of credit, you have to pay your lender interest. However, interest isn’t the only cost associated with borrowing money. You may also have to pay:
- Closing costs
Unlike interest rates, APRs take these extra costs into consideration. In turn, APR is a more accurate estimate of the total cost of borrowing money than an interest rate. (If your lender doesn’t charge any fees, closing costs, or insurance, your APR will be the same as your interest rate.)
Another key difference is that interest rates may apply to shorter periods of time, while APRs express the annual rate for borrowing money. With that in mind, here’s the formula for calculating APR:
APR = Periodic Interest Rate x Number of Periods in a Year
Accruing Interest with APR
While APR offers a more comprehensive look at the cost of borrowing money, it doesn’t factor in compound interest. Compound interest is interest that’s calculated on your original principal amount, as well as any accumulated interest from previous periods. In other words, it’s interest on interest.
Let’s say you borrow $100 on your credit card with a 15% APR. After carrying that balance for a month, you now owe $115 ($100 x 0.15). You carry that balance for another month and now owe $132.25 ($115 x 0.15).
As you can see, charging interest on the interest you accrued from previous periods can quickly increase the total cost of your debt.
What Is APY?
APY is an annual rate that lets you know how much money you can earn in interest on your savings or investments each year. It’s sometimes referred to as the Effective Annual Rate (EAR).
Financial institutions typically advertise APY on the following types of accounts:
- Savings accounts
- Checking accounts
- Money market accounts
- Certificates of deposit (CDs) or Term Share Certificates
- Individual retirement accounts (IRAs)
APY factors in compound interest. Thus, its calculation is a little more complex than APR. Here’s the formula for APY:
APY = (1 + Periodic Rate) Number of periods – 1
Earning Interest with APY
Here’s an example of APY in action. You’re considering depositing your money into two savings accounts that boast an interest rate of 0.25%. One of these savings accounts compounds interest daily, while the other does so quarterly. In other words, these savings accounts have 365 periods and four periods, respectively.
After plugging these numbers into the APY formula, you discover that the APYs for these accounts are as follows:
- Daily savings account – 0.2503%
- Quarterly savings account – 0.2502%
While these rates aren’t drastically different from one another, you’ll earn more money over time by placing your money in the savings account that compounds daily.
What Is a Good APR or APY?
Now that you understand the distinctions between APR and APY, you may be wondering what range of rates is considered “good.”
When it comes to APR, the lower the better. Having a low APR means that you’ll owe your lender less money. APR ranges vary notably from one form of financing to the next. To enjoy the lowest rates, you’ll typically need a higher credit score.
In contrast, you want to seek out the highest APY you can find. A high APY will enable you to earn more money on your savings.
How to Get a Good APR or APY
You can set yourself up to get the best APRs and APYs by:
- Ensuring you have a high credit score before you apply for financing
- Comparing your options among different financial institutions
- Working with a credit union, as opposed to a bank or online lender
APR vs. APY: The Bottom Line
To summarize, APR and APY are both important rates to consider when shopping for financial products. APR helps you calculate the total cost you will pay of borrowing money, while APY expresses your earning potential with saving accounts with compound interest factored in.
If you want to enjoy lower rates on loans and higher returns on savings, you may want to consider joining a credit union. Compared to banks and online lenders, credit unions tend to offer the most favorable APRs and APYs.
Find a credit union near you today.