APY vs APR: What’s the Difference?
When it comes to investing and saving money, understanding the difference between APY and APR is crucial. These two financial terms are often used interchangeably, but they refer to different things. In this article, we will explain the difference between APY and APR and how they are calculated.
APY, or Annual Percentage Yield, is the total amount of interest earned on a deposit or investment over the course of a year. APY takes into account the effect of compounding interest, which means that interest is calculated on the principal plus the accumulated interest. In other words, APY is the rate of return you can expect to earn on your investment or deposit over a year.
For example, if you deposit $10,000 into a savings account that pays an APY of 2%, you will earn $200 in interest at the end of the year. However, if the savings account compounds interest daily, the interest earned will be slightly higher than $200, because the interest earned on each day’s balance is added to the principal and begins earning interest as well.
APR, or Annual Percentage Rate, on the other hand, is the total cost of borrowing money, expressed as a percentage of the loan amount. APR takes into account not only the interest rate, but also any fees or charges associated with the loan, such as origination fees, closing costs, and other costs. APR is usually used for loans such as credit cards, mortgages, and car loans.
For example, if you borrow $10,000 at an APR of 5%, the total cost of the loan for one year would be $500. However, if there are additional fees associated with the loan, the APR will be higher than 5%.
APR and APY are calculated differently, which is why the numbers can be confusing. APR is a simple interest rate, meaning that it only takes into account the interest charged on the principal amount of the loan. APY, on the other hand, takes into account the effect of compounding interest.
To illustrate the difference between the two, let’s say you invest $10,000 in a certificate of deposit (CD) with a 2% APY for one year. At the end of the year, you will earn $200 in interest. However, if the CD compounds interest quarterly, the interest earned will be slightly higher than $200, because the interest earned on each quarter’s balance is added to the principal and begins earning interest as well. In this case, the APY will be slightly higher than 2%.
It’s important to note that APY and APR can be misleading if you’re not comparing apples to apples. For example, a credit card with a 0% APR for the first six months may seem like a great deal, but if the card charges a high annual fee, the true cost of the card will be much higher than the APR alone suggests.
Similarly, when comparing savings accounts or investment opportunities, it’s important to look at the APY and any other factors that could affect your return, such as fees, penalties, or minimum balance requirements. A higher APY does not necessarily mean a better investment if the fees associated with the account are high.
In conclusion, understanding the difference between APY and APR is crucial when it comes to investing and borrowing money. APY is the rate of return you can expect to earn on an investment or deposit, taking into account compounding interest. APR is the total cost of borrowing money, taking into account the interest rate and any fees or charges associated with the loan. When comparing financial products, it’s important to look at both the APY and APR, as well as any other factors that could affect your return or cost.
