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Difference between APR and APY

It is important for you to know about the interest rates when you want to put your money into the interest bearing investments, finance a loan, get a savings account, checking, or money market accounts. Banks and other financial institutions often use the terms APY and APR, but many people do not know what these terms really mean, or how they differ. These acronyms are widely used by the banks, so every individual should know what the difference between the two is, and it can only be done if you know what these terms mean.

Definition of APR and APY

Annual Percentage Return, or APR, is a simple rate of interest that is earned by the account holders, or the investors. It is the annual interest rate, which does not take into account the compounding of interest in a year. When you talk about APR in the context of savings, it actually represents the periodic rate or simply the rate. For example, if you deposit $1,000 in your account with 10% APR, and this interest is only charged once a year, it means you will earn an interest of $100 after a year. However, you can also get to make money by earning interest on your interest and this is what the APY is all about, because it takes into account the compounding of interest.

Annual Percentage Yield, or APY, is an interest yield that is received by an individual on the account balance he holds for a year as an investment or savings. It is the effective rate of return earned annually after considering the concept of intra-year compounding interest. For example, based on the above example, if you have $1,000 in your savings account with the 10% rate of interest that is paid bi-annually. For the first 6 months, you will be paying $50 ($1,000*10%/2). However, for the second half of the year, you will now be paying the interest on the total amount of $1,050 after adding the $50 earned in the first 6 months. The formula to calculate the APY is:

APY = (1+r/m)m – 1

Where, ‘m’ is the frequency of compounding in a year, such as, quarter, biannually, etc., and ‘r’ is the nominal rate of interest charged annually. Now, in the second half, the result will be $52.5 (1,050*10%/2), giving a total rate of interest earned in a year of $102.5, which is slightly higher than the APR of $100. The APY will now be 10.25% ($102.5/$1,000*100). The higher the frequency of paying the interest in a year, the bigger will be the difference between APR and APY.

Borrower’s Approach to APR and APY

When you want to borrow a loan or apply for a mortgage or a credit card, you prefer to have the lowest rate of interest, and in order to get the real picture of the actual cost of the credit, you need to understand the basic difference between the two. For example, when you apply for a loan, you may choose a lender that is providing the lowest possible rate, but it is highly likely that it ends up costing you more than you originally thought it would, because the lender will be showing you the APR, and not the APY.

Lender’s Approach to APR and APY

Being a lender, you always look for the highest rate of interest and banks and other financial institutions usually conceal the APR and advertise the APY instead to attract the lenders, since there is some compounding of interest involved during that financial year.

So, this is how both APR and APY are different from each other. The difference between the two rates can have a significant effect on the financial decisions of borrowers and investors. To summarize it, you can say that the financial institutions usually highlight the APY in order to attract the investors in case of savings account, and show how high the rate of interest is. Whereas, when you apply for a credit card or a loan, the APR is highlighted in order to hide the actual cost an individual will be paying. Therefore, whenever you apply for a loan or get a savings account, you should follow the like with like approach, and should not compare the APY of one product with the APR of the other as it will provide you a true picture of which is more suitable for you.

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