APR vs APY

One of the smartest man to be born on Earth, Albert Einstein, had famously quoted that compound interest is the greatest force on earth. This is, indeed, a very strong statement from the great man. Without dissecting his opinion, we look at what matters to common people like us.

The point of compound interest was discussed in the earlier paragraph as it is the most crucial distinguishing factor when it comes to the APR or the APY. Compounding is done in APY, while APR is a much more straight-forward calculation. We come across these terms when looking for loans or investments, and often wonder the difference between the two and which rate should be considered when.

Annual Percentage Rate (APR)

Annual Percentage Rate (APR) is the term used to define the interest paid on credit card, mortgage or any other type of loan. The APR is applicable on any interest rate and is either equal to or lesser than APY. It is simple to calculate APR as it does not involve any complex calculations because the rate is directly employed on the money borrowed. In case the APR for your credit card is 15%, it is applied by the credit card company, everyday, on your average credit card balance post the grace period. On looking at the credit card statement, you will notice that the 15% APR is divided by 365 (days in a year), which brings the daily periodic rate to 0.04109%. Thus, if you are paying off the total balance amount every month, after the 15% interest rate is applied, then you pay less compared to what you would be paying if you carry forward your balance to the next month.

Annual Percentage Yield (APY)

Annual Percentage Yield (APY), is a term used to define the interest paid in a checking, savings or any other type of interest assuming account. Since APY also accounts for interest paid on the initial interest amount, it is always more than APR. This interest is compounded either on a daily, monthly, or quarterly basis, this interest is added to your average daily balance. The next time when APY is calculated, the previous APY amount is already added to the balance and hence a higher figure derived. Thus, except when you withdraw from an interest bearing account, your interest deposits will always be more than what was calculated the previous time.

An Example of Comparison

To help you get a better picture of the debate, let us look at an example. Assume that you have a savings account which pays you interest at the rate of 3% annually. You deposit US $5000 in this account. On dividing 3% by 12 months, you get a monthly interest rate of 0.25%. But when you calculate interest on the amount for a year on the 5000 dollars, by applying the interest rate only once, you will get the annual interest as US $150. However, a monthly calculation of the interest rate at 0.25% per month would give you a much higher interest on the 5000 dollars you have in the account.

Month	Amount
1	5,012.50
2	5,025.03
3	5,037.59
4	5,050.19
5	5,062.81
6	5,075.47
7	5,088.16
8	5,110.88
9	5,113.63
10	5,126.42
11	5,139.23
12	5,152.08

You can therefore see that the interest calculated through APY is US $152.08 and not US $150, as calculated through APR. Another important point is that more times the APY is calculated, higher your interest gain will be. In this case it is calculated on a monthly basis and hence, the amount will be more than what you would have arrived at by calculating the interest quarterly.

From the Borrower's and Lender's Perspective

When you are the borrower, you are looking for the lowest possible interest rate, as you will be paying back the borrowed amount with interest. In such case, it is important to know what is the difference between APR and APY, so that you do not end up paying a lot of interest.

Banks normally quote you the APR. As discussed earlier, this figure does not account for the compounding done monthly, quarterly or semi-annually. For example, if the bank has quoted an interest rate of 7%, it does not take into account any compounding of the interest rate. When you consider the compounding, the interest rate goes up by 0.23%, which you eventually end up paying on your loan amount every year. This emphasizes the fact that is vital to ask your lender whether he is charging you with the APR or APY on the interest.

The lender (bank in this case) will always hope that the individual opens an account and saves money with the bank. This is the reason that banks quote APY when you look to open an account with them, as this rate is higher and hence would lure you towards the bank. They will seldom quote the APR as this rate is lower than the APY, provided the amount is compounded few times during the year. You should know the difference between APR and APY so that you open an account which will pay you the highest interest.

Thus, understanding the APR vs APY distinction will help you make smarter borrowing and saving decisions. Even if you have weak financial knowledge, you cannot be fooled, once you know this difference. Use your knowledge and calculate the interest rate on savings or borrowings, to get the actual picture.