Does one letter make a difference? In the case of APR and APY, the answer is absolutely yes. Financial terms and concepts can sometimes feel tricky, especially when moving to a new country. However, gaining the information and understanding you need is imperative to your financial health and wellness.
Remitly is committed to helping you manage your money well. In this article, we’ll break down the key differences between APR and APY in US banking, and how these concepts will impact your financial decision-making.
APY vs APR: understanding the core concepts
Whether you’re a business owner or an individual, interest is an important part of financial planning. However, it can be difficult to understand the two most commonly encountered terms when it comes to interest rates: APR and APY. While they both discuss interest, there are key differences to understand in order to make smart financial decisions.
Defining Annual Percentage Yield (APY)
When you are the party earning interest from a relationship, Annual Percentage Yield (APY) is the figure that determines the amount of money you earn. In other words, APY is a good thing! It’s your money making money.
Defining Annual Percentage Rate (APR)
On the other hand, the Annual Percentage Rate (APR) is the amount of interest that you have to pay a lender when you owe money. In any situation where you are borrowing money, including credit cards, business loans or student loans, you want your APR to be as low as possible.
Importance of knowing the difference
Sometimes it feels like the terminology of finance is designed so that the average person cannot understand it. But, when you get down to the nitty gritty, it really is quite simple:
- APY represents money you stand to earn. You want APYs to be as high as possible.
- APR represents money you’ll have to pay. You want APRs to be as low as possible.
Despite this key difference, there are some similarities between the terms. In both phrases, “A” stands for “annual.” This means that both figures are calculated based on the time frame of a year. “P” stands for “percentage.” This means that the amount of money discussed in both figures is variable based on how much money you’re depositing or borrowing.
How APY and APR impact financial decisions
APY is used to understand savings and investments. APR is used to understand loans and credit. Understanding the fine print around what these figures are and how they are applied to any financial agreements you enter into will impact your financial decisions.
The role of APY in savings accounts
The first thing to remember is that a higher APY in savings accounts is a good thing. It represents the amount of money you stand to earn by depositing money into that account. Choosing an account with a high APY means that your money will be working for you even as it’s sitting in your account.
You’ll want to look for savings and investing accounts with high, compounding APYs. We’ll talk a bit more about simple versus compound APYs later in this article.
How APR affects borrowers and lenders
APR represents the fee you’ll have to pay to borrow money from someone else. This significantly affects borrowing costs, because any loan with APR applied means you’ll end up paying more than what you borrowed. For lenders, APR increases their profitability and lowers their exposure to risk.
If and when you’re considering taking out a loan or opening a credit card, it’s important to shop around and compare different lenders. Comparing loans by APR is a good marker because it represents the fees and interest you’ll pay to borrow.
APR isn’t assigned at random; it’s based on your creditworthiness. If you’re a borrower with a demonstrated ability to manage credit and pay back loans in a responsible and timely manner, your APR will be relatively low. If you frequently miss payment deadlines, don’t complete payments in full, or take a long time to pay back loans, you’ll receive relatively higher APR rates. This means that it’s important to build your credit history, especially if you have big financial goals for the future.
Evaluating financial institutions based on interest rates
Analyzing and comparing interest rates is an important part of choosing which financial institution to bank with. In addition to looking at types of accounts available and fees charged, be sure to check the APR and APY rates offered.
Calculating interest: simple versus compound
Now that you understand the concept and importance of interest, let’s actually crunch some numbers with some practice calculations.
Keeping it simple
There are two options for how APY is calculated: simple interest or compound interest. Simple interest does not incorporate previous interest into calculations. It only takes into account the money that you yourself deposit.
If you deposit $100 USD into a savings account with 5% simple APY, you’ll finish the year with $105 USD. This sum represents your initial $100 USD investment plus 5% of the total.
The impact of compounding APY
Even though it’s a bit more complicated, most APY rates are compounding. This means that the interest is calculated based on the total of your account, including deposits and past interest. To figure out how much money you stand to make, follow the APY formula below. Make sure you consider the compounding frequency when deciding on an account. This can be daily, monthly, quarterly, or annually.
| APY = (1 + r/n)^n – 1
Where “r” is the interest rate and “n” is the number of times interest compounds per year |
It’s complicated—in a good way—when interest is compounding. Let’s consider a similar situation to the hypothetical one above: you deposit $100 USD into a savings account with 5% APY, but this time it’s compounding monthly. You’ll finish the year with way more than the $105 USD you’d get with simple interest. This is because you earn 5% each month, which is then added to the total. The next month, the larger sum is used to calculate the interest.
Real-world calculation example
Here’s an example of the first three months of the hypothetical situation described above—a balance of $100 USD in a 5% APY account, compounding monthly:
- January
Initial balance: $100 USD
Compounding 5% Interest: $5 USD
Month Total: $105 USD
- February
Initial balance: $105 USD
Compounding 5% Interest: $5.25 USD
Month Total: $110.25 USD
- March
Initial balance: $110.25 USD
Compounding 5% Interest: $5.5125 USD
Month Total: $115.7625 USD
If you have ever heard that trick question, “Would you rather have $1 million USD today or a single penny that doubles every day for 30 days?”, you probably know that the better answer is to take the penny. The second option is better because of compounding interest. In this riddle, there is an APY of 100% compounding daily! After thirty days of doubling a penny, you’d end up with over $5 million USD. That’s the power of APY.
APY and APR: key differences in practical scenarios
At the end of the day, APY and APR are probably going to come up frequently in your financial decision-making. Here are some practical scenarios where you might consider these interest-based terms.
Application in personal loans and credit cards
Let’s say you want to borrow some money through a personal loan or by applying for a credit card. This scenario is directly connected to understanding APR. Because APR is the amount of money you’ll pay the financial institution for lending you money, you want this figure to be as low as possible.
Consider different options and compare the APRs to make an informed decision. Take into consideration the terms of how APR is applied. Sometimes, lenders will have a grace period after a loan comes due or after opening a credit card when APR is 0% for a set amount of time. If possible, pay off your loan within the APR-free period. This would mean that you borrowed money without any additional costs.
How savings accounts benefit from APY
When you’re considering a savings account for yourself or your business, try to look for one that has a high APY. You’ll also want to find an account with a frequently compounding APY.
Although it is not as common, there are some checking accounts that offer APY so that you can earn interest on money in the account while also using it for daily expenses.
Comparing APR and APY in investments
In general, you want to maximize your APY and minimize your APR across all accounts and investments. However, you might have heard the term “good debt.” This generally refers to debt that will help you increase your net worth or generate future income. It is also typically marked by low APR. Financial specialists suggest that anything 6% or below is considered low.
An example of a “good debt” investment might be a student loan that will allow you to increase your yearly salary. A mortgage on a house in an area where real estate is increasing in value would also be “good debt.”
Final thoughts: making informed financial decisions
Financial decision-making is not always easy, but having the right information can make it much less stressful. Here are the key takeaways you need to understand APY and APR.
How understanding interest rates maximizes financial returns
Interest refers to a percentage of money that you either earn or owe. If you earn the money, it’s APY. If you owe the money, it’s APR. Maximizing your APY and minimizing your APR is going to ensure that you have a financial return that is as high as possible.
Tips for savvy consumers and investors
Remember the following tips as you move forward in your financial planning journey:
- Increase APY as much as possible. Look for accounts with frequently compounding APY.
- Lower APR as much as possible. Attempt to pay off loans immediately, without accruing any interest.
- Compare the offerings of different financial institutions based on interest rates.
- Establish a strong credit history to access lower APR loans.
Resources for continuing your financial education
If you’re looking to continue your financial education, consider the following free resources:
- University of Illinois Urbana-Champaign Financial Planning for Young Adults Course
- University of Florida Personal & Family Financial Planning Course
- Duke University Behavioral Finance Course
FAQs
Is it better to accrue APR or APY?
Hands down, APY is what you want to accrue. APY is money that’s going into your pocket, while APR is money that you owe lenders.
Should I use APR or interest rate?
When you’re considering a loan, APR typically refers to what you’ll owe a lender, including all interest and other fees. Interest rate is the percentage of the loan amount you’ll have to pay back in addition to the principal amount, excluding other fees.
As a result, it is typically best to consider APR so that you have a holistic view of the total cost of borrowing money.
What does 5.00% APY mean?
In general, 5.00% APY means you’ll potentially make money on your investment. However, in order to calculate how much you’ll earn, you need to know whether the APY is simple or compounding, and how many times per year it compounds.