Annual Percentage Rate vs. Annual Percentage Yield: What’s the Difference?
You’ve probably heard these terms before, but what do they really mean? Read on to find out.
For credit cards, the APR is just the interest rate you pay when you don't pay your balance in full each month. For installment loans like personal loans or auto loans, the APR incorporates the interest rate plus additional fees and other costs. It does not take into account how many times the rate is applied to the balance. The more frequently the rate is applied to a balance, the higher the total amount you’ll pay.
Compounding adds accrued interest to your balance each period, so your balance increases with each new period. The interest rate is then applied to your new growing balance (principal + accrued interest). Interest can be applied daily, monthly, quarterly, or semi-annually. More frequently compounded interest will result in a higher yield, which ultimately means more money in your pocket.
APR or Annual Percentage Rate
APR represents the total cost of borrowing money over the course of one year. You'll see APRs disclosed on accounts like auto loans, mortgages, home equity loans, personal loans, and credit cards. APR is determined by creditworthiness, so a higher credit score usually means you'll have a better APR (and, ultimately, a lower cost of borrowing for you).For credit cards, the APR is just the interest rate you pay when you don't pay your balance in full each month. For installment loans like personal loans or auto loans, the APR incorporates the interest rate plus additional fees and other costs. It does not take into account how many times the rate is applied to the balance. The more frequently the rate is applied to a balance, the higher the total amount you’ll pay.
APY or Annual Percentage Yield
APY refers to the interest you earn from a savings or checking account. Unlike APR, APY takes into account compounding interest to give you the best picture of what you'll earn in one year.How compound interest works
Compounding adds accrued interest to your balance each period, so your balance increases with each new period. The interest rate is then applied to your new growing balance (principal + accrued interest). Interest can be applied daily, monthly, quarterly, or semi-annually. More frequently compounded interest will result in a higher yield, which ultimately means more money in your pocket.
Let's say you have $1,000 in a certificate that earns .45%, compounded quarterly.
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A January investment of $1,000 x .0045 earns $4.50 at the end of March.
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In Q2, $1,004.50 x .0045 earns $4.52 the end of June ($1,009.02).
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In Q3, $1,009.02 x .0045 earns $4.54 at the end of September ($1,013.56).
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In Q4, $1013.56 x .0045 earns $4.56 at the end of December.
That means the new balance on December 31 is $1,018.12.
Remember: APR doesn't take compounding interest into account, whereas APY does. It's important to understand how it can work both in your favor and the other way around. The interest on your debt can add up just as quickly as the interest on your savings or certificate accounts if you aren't aware of how it works.