APR Vs. APY in Interest Rates
It's not immediately clear from their names how the two terms — and the interest rates they describe — differ. However, understanding the difference between APR and APY will help you understand exactly how hard your money is working for you.
APR vs. APY: It’s All About Compounding
APR reflects the annual interest rate that is paid on an investment. It doesn’t take into account how interest is applied.
Meanwhile, APY takes into account how often the interest is applied to the balance, which can range anywhere from daily to annually.
For example, let’s say you deposit $10,000 into an 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 the 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
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.
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.
If you are comparing one account advertising its APR with another’s APY, the numbers might not reflect which account is better. When comparing the APY of both, you have a clear picture that shows which account will yield more interest.