Compounding interest can be a powerful tool for increasing wealth. When interest compounds, you effectively earn interest on your interest, and the longer your time frame for investing and saving, the more potential your money has to grow.
Both APR (annual percentage rate) and APY (annual percentage yield) are commonly used to reflect the interest rate paid on a savings account, loan, money market, or certificate of deposit. It's not immediately clear from their names how the two terms — and the interest rates they describe — differ.
Understanding what APR and APY mean and how they're calculated can give you a better idea of just how hard your money is working for you.
APR vs. APY: It’s All About Compounding
APR and APY can be defined in relatively simple terms. In the context of savings accounts, the APY reflects the annual interest rate that is paid on an investment. In the context of borrowing, APR describes the annualized interest rate you pay on credit cards, loans, and other debts. It includes both the interest rate on what you borrow, as well as any fees the lender charges.
Respectively, the formulas for both are as follows:
- APR = Periodic rate X Number of periods per year
- APY = (1 + Periodic rate)^Number of periods - 1
The biggest difference between APR and APY lies in how they relate to your savings or investment growth, or the cost of borrowing.
With savings or investments, APY factors in how often the interest is applied to the balance, which can range anywhere from daily to annually. Essentially, the more frequently your rate compounds, the faster your money grows. APR doesn't work the same way.
Here's an example to illustrate how compounding works. Say you deposit $10,000 into an online savings account that has an APR of 5 percent. If interest is only applied once per year, you would earn $500 in interest after one year.
On the other hand, let’s say that interest is applied to your balance monthly. This means that the 5 percent APR would be broken down into 12 smaller interest payments for each month.
In this case, that would amount to about 0.42 percent per month in interest. Using this method, your $10,000 deposit would actually earn $42 in interest after the first month. That means in the second month, 0.42 percent would be applied to the new balance of $10,042, and so on.
Therefore, in this example, even though the APR is 5 percent, if interest is compounded once a month, you would actually see almost $512 of earned interest after one year. That means the APY turns out to be around 5.12 percent, which is the actual amount of interest you’ll earn if you hold the investment for one year.
Of course, if you're considering an investment where the interest is only applied to the balance once every year, your APR will be the same as your APY. This is not a common scenario, however, and you're unlikely to encounter it at your bank.
Banks Mostly Advertise APY for Savers
When banks are seeking customers for interest-bearing investments, such as certificates of deposit or money market accounts, it's in their best interest to advertise their best annual percentage yield, not their annual percentage rate.
The reason for this should be obvious: The annual percentage yield is higher, and so it looks like a better investment for the consumer. Finding a high APY should be a priority, however, as the higher the APY, the more potential your money has to grow thanks to compounding.
The reverse would be true with APR in a borrowing scenario, on the other hand. If you're getting a car loan, mortgage, credit card, or any other type of financing, you'd want the APR to be as low as possible. The lower the APR, the less interest you'll pay over the loan or line of credit's repayment period.
Also, keep in mind that APRs, as they're associated with borrowing, may be variable or fixed. A variable rate can fluctuate up and down over time, in tandem with movements in the index rate that it's tied to. A fixed APR, by comparison, would stay the same for the entire length of the repayment term, allowing for predictability in your monthly payments and the total amount of interest paid.
Always Compare the Same Types of Rates
When shopping for a new savings account, CD, or money market account, make sure that you are comparing apples to apples. That means when you are considering interest rates, you’re comparing APY to APY or APR to APR, rather than blending the two.
If you're comparing one account advertising its APR with another’s APY, the numbers might not offer a true reflection of which account is better. When comparing the APY of both, you have a clear picture that shows which account will yield more interest over time.
Something else to remember when comparison shopping: check what traditional brick and mortar banks or credit unions offer against what you can find from online banks. Online banks tend to have lower overhead costs than traditional banks and thus are in a position to offer higher APYs on deposit accounts. Online banks may also charge fewer fees and have lower initial deposit requirements, which can also make them more attractive than brick-and-mortar banks.