Annual percentage yield (APY) and annual percentage rate (APR) are both used to calculate interest on account balances during a one-year period. APY refers to the interest you can earn on your bank deposits and investments. APR is the interest that you must pay for borrowing money from credit accounts, such as loans, mortgages, and credit cards.
APY vs APR
The main difference between APY and APR is the type of accounts to which they are applied. The annual percentage yield (APY) is used to measure how much interest you will earn on a deposit or investment account during a year. Meanwhile, the annual percentage rate (APR) refers to the interest that you pay for borrowing money from a financial institution. This is the amount of interest a bank charges on credit products like loans and credit cards.
What Is APY?
APY refers to the amount of interest you will earn on a bank account for a period of one year. APY includes the compounding of interest, which is the interest earned on both the principal balance and earnings. To calculate APY, you need to consider the annual interest rate and the frequency of compounding periods each year.
How APY Works
APY works by taking into account the interest rate and the number of compounding periods within a year. Compounding lets you earn interest on both your principal balance and the earnings credited to your account. If the number of compounding periods on your account each year is more frequent, you will earn a little more every time your interest earnings are credited to your account.
How APY Is Calculated
To calculate APY, we use the following basic formula:
APY= (1 + r/n )^n – 1
Based on the formula, “r” refers to the stated annual interest rate, and “n” represents the frequency of compounding periods in a year. The interest can be compounded daily, quarterly, monthly, or annually, depending on the bank and the type of account. The number of compounding periods in a year can greatly affect the overall APY.
For example, the annual interest rate of a certificate of deposit account is 5%, and it pays interest on a monthly basis. Using the formula, we calculate the APY as follows:
APY = (1 + 0.05/12)^12 – 1
APY = 5.12%
If the account pays 5% annual interest on a daily basis, the APY is calculated as:
APY = (1 + 0.05/365)^365 – 1
APY = 5.13%
These examples show that the frequency of compounding periods each year can affect the APY. If the interest is compounded more frequently, you will get a higher APY. Higher APYs can affect your earnings significantly, especially if you have a high account balance.
What Type of Account Is APY Applied To?
APY is generally applied to deposit products such as savings and checking accounts, certificates of deposit, and money market accounts. It also applies to investment products like individual retirement accounts (IRAs), securities, and bonds. Financial institutions and investment companies often prominently advertise the APY to attract depositors and investors. In general, APY provides an accurate overview of how much your money could earn in a year.
APY Example
APY takes into account several factors like the interest rate and the number of compounding periods every year to show your account’s earning potential.
To give you an idea of how APY works, let’s look at the following example:
A high-yield money market account that pays interest on a monthly basis has an interest rate of 0.50% and an APY of 0.51%. The 0.01% difference between the interest rate and the APY is the effect of compounding. If you make a $2,000 deposit and earn a simple interest of 0.50% annually, your balance will become $2,010 after 12 months.
Since APY includes compounding, it takes into account the interest earned on both your principal balance and prior interest earnings. This account earns interest every month, which means your total balance will also increase every time your interest is credited to your account. Due to compounding, you’re going to get a little more interest than the previous month. The monthly compounding lets you earn around 0.51% interest in one year.
From our example above, your balance after 12 months would be $2,010.20. The additional 20 cents is the result of the compounded interest earned on the account. The 0.01% difference between the standard interest rate and the APY will have a more significant impact if your account balance is higher.
What Is APR?
APR refers to the annual rate of interest financial institutions charge to borrowers on credit accounts. It is a percentage that represents the actual annual cost of funds during the term of a loan, mortgage, or borrowing from a credit card. In general, lenders determine your APR based on different factors, including the type of loan, your creditworthiness, and your banking relationship with the lender.
How APR Works
APR represents the annual percentage of the loan principal that borrowers need to pay yearly as the cost of borrowing money. APR does not take into consideration the compounding interest within a year. However, it may include any fees or additional costs associated with the credit transaction. To determine the APR, you need to take into consideration the interest rate, the loan amount, the loan term, and any additional fees.
How APR Is Calculated
The basic formula to calculate APR is as follows:
APR = {[((Fees + i) / Loan Amount) / n] x 365} x 100
Based on the formula, “i” represents the interest paid during the life of the loan, and “n” refers to the number of days in the loan term.
To calculate APR, you need to add the fees and total interest paid during the life of the loan, then divide the sum by the loan amount. You will then divide this by the total number of days in the loan term and multiply it by 365 (the number of days in a typical year). This result is then multiplied by 100 to convert the annual rate into a percentage.
For example, you take out a $5,000 loan at 5% interest for three years. You also need to pay a closing fee of $200. To calculate the APR, you need to:
1. Find the interest on this loan using the simple interest formula:
Interest = P x R x T, where P = principal, R = interest rate, and T = term of the loan
In this case, P = $5,000, R = 5%, and T = three years.
Interest = 5,000 x 0.05 x 3
Interest = $750
2. Once you determine the amount of interest paid during the life of the loan, you need to add it to the closing cost:
$750 + $200 = $950
3. Then, divide this by the loan amount:
$950/$5,000 = 0.19
4. You will then divide this by the number of days in the loan term. Based on our example, the loan term is three years, which is a total of 1,095 days:
0.19 / 1,095 days = 0.0001735
5. Finally, you multiply this by 365 and multiply again by 100 to get the percentage:
0.0001735 x 365 x 100 = 6.33%
From the above example, the APR is 6.33%.
What Type of Account Is APR Applied to?
APR is typically applied to credit accounts such as mortgages, loans, and credit cards. Lenders and financial institutions generally display APR to give borrowers an overview of how much a loan would cost during a period of one year. It’s important to note that unlike APY, APR does not include compounding.
APR Example
In general, APR is the total amount of interest you pay annually for a loan, mortgage, credit card, or any type of credit account. It is represented as a percentage of the loan balance.
To give you an overview of how APR works, let’s consider the following example:
Let’s say a personal loan has an APR of 10%. If you take out a loan amounting to $2,000, the annual interest you can expect to pay is $200—this is the amount of interest the bank will earn for lending you the money.
Financial institutions typically offer either fixed or variable APR. When the APR is fixed, the rate does not change in time, no matter what the market condition is. For example, if you have a fixed-rate loan with a 10-year term, your APR remains the same throughout those 10 years until your term ends. With a variable APR, the rate can go up or down depending on the current prime rate.
How Financial Products Market APY and APR
Financial institutions and investment companies generally market their financial products using APY to attract depositors and investors because it shows that they will earn more interest in a year due to compounding. As a depositor or investor, it’s important to look for financial products that offer high APYs and low fees to get the best value for your money.
Meanwhile, lenders and credit companies advertise their credit products using APR since it shows that borrowers end up paying less in the long run for credit accounts. As a borrower, it’s more prudent to work with lenders or credit companies that offer low APRs on loans, mortgages, credit cards, and other types of credit products.
Frequently Asked Questions (FAQs)
1. Why is it important to know the APR and APY of a bank or credit account?
It is important to understand the concept of both APR and APY so you can manage your business and personal finances more efficiently. Knowing the APR of a credit product allows you to choose to work with the lender that offers the lowest interest rate possible to help lower your overall cost. Similarly, it’s essential to know the APY of deposit and investment products before opening an account as it provides you with an overview of your earning potential.
2. How does compounding in APY affect my earning potential?
Compounding interest is considered when calculating the APY of an account. If the interest compounds more frequently, your account will have a higher earning potential. The frequency of compounding each year is an important factor to consider when shopping for a deposit or investment account. This will make a significant difference in your earnings, especially if you have a higher account balance.
3. Do credit accounts include compounding?
Most banks and lenders often quote the APR on the loan and other credit products to make the quoted rates appear low. However, this figure does not include any intrayear compounding of the loan, either semi-annually, quarterly, or monthly. Intrayear compounding may be applicable in some credit products. The APR is simply the periodic rate of interest multiplied by the number of periods in the year. However, if the lender applies intrayear compounding, you could end up paying more interest than you anticipated originally.
Bottom Line
Understanding the concepts of APY and APR is essential in helping you find the best bank products that meet your financial needs. When shopping for a deposit or investment account, make sure to compare the APYs quoted by different banks. Similarly, when shopping for a loan product, comparing the APRs of multiple lenders can help you save money on interest during the term of the loan.
