By Kristina Russo | American Express Credit Intel Freelance Contributor
7 Min Read | January 31, 2020 in Money
When comparing interest rate offers, it’s important to know the exact meaning of the different rates you are assessing.
Knowing the difference between annual percentage rate (APR) and annual percentage yield (APY) can be critical to choosing the best interest rate.
The usefulness of each kind of rate can depend on whether you’re borrowing or investing.
If you’re wading into the waters of borrowing or investing for the first time you may be drowning in unfamiliar terms such as nominal interest, DPRs, APRs, APYs, EARs, and AERs. Consider the following overview of important differences between interest rates, APR, and APY your life preserver in this alphabet soup.
Perhaps the most practical things to know about annual percentages rates (APRs) and annual percentage yields (APYs) are that:
That difference in purpose of APRs vs APYs leads to their other main differences:
But if you’re brand new to borrowing or investing, there’s more you need to know in order to use the APR vs APY vs interest rate differences outlined above in the real world.
Interest is what a lender charges you to borrow a set amount of money (the principal), usually quoted as an annual percentage. Interest charges are added to the principal, and a borrower must repay the entire sum. For detailed information on interest rates and how to compute them, see “How to Calculate Interest Rates.”
There are two different methods of computing interest charges:
APR is a way of measuring the all-in costs a lender charges a borrower per year. If there are no fees, the APR equals the nominal interest rate. If there are fees, a loan’s APR is its nominal interest charges plus any “fine print” costs, such as:
APR is shown as a percentage of the loan amount that you pay each year. The higher the APR, the more money you will pay back over the life of the loan. Personal loans, auto loans, and some student loans tend to use the simple interest method.
APR can help you decide which loans make the most sense for you by creating a level field to compare total borrowing costs. It helps you figure out whether to choose a financing plan with a higher nominal interest rate and lower upfront fees, or one with some extra fees upfront (such as points on a mortgage) that get you a lower interest rate. For more detailed APR information, see “What is APR and How to Calculate It.”
Although primarily a tool for savings and investment, APY can be applied to borrowing as well. Here’s how the differences of APY vs APR are important if used for borrowing.
Don’t be fooled if someone starts talking to you about an effective annual rate (EAR) or annual equivalent rate (AER)—they’re just more ways to say APY.
Most times you’re looking to maximize interest when you’re investing but minimize it when borrowing. When making a savings deposit or investment, APY may be more helpful, especially for comparing alternatives with different compounding rates.
By way of example, consider two savings vehicles:
Because of the differences between APR and APY, lenders (such as credit card issuers and banks) usually market their interest rates on borrowing using APR, so it looks lower. Interest rates on investments (such as savings accounts, certificates of deposit, Treasury Bills, and bonds) are usually marketed using APY, which looks higher.6
When comparing interest rate offers for mortgages, home equity lines of credit, car loans, credit cards, certificates of deposit, or savings accounts, it’s important to know exactly what the rates you are looking at mean. Understanding interest rates and the differences between APR and APY can help you compare rates confidently.
Show Article Sources
2 “Loan Calculator,” Calculator.net
3 “Annual Percentage Yield (APY),” The Balance
4 “APR vs APY: Why You Need to Know the Difference,” Student Loan Hero
5 “APR vs APY: Why the Difference Between Matters,” U.S. News & World Report
6 “APR Vs. APY In Interest Rates,” The Balance