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The Differences Between APR, APY, and Interest Rates

APR and APY both include interest rates, but one is mostly for borrowers and the other for investors. Learn more about the differences between APR and APY.

By Kristina Russo | American Express Credit Intel Freelance Contributor

7 Min Read | January 31, 2020 in Money

 

At-A-Glance

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.

 

APR vs APY vs Interest Rate: The Cheat Sheet

Perhaps the most practical things to know about annual percentages rates (APRs) and annual percentage yields (APYs) are that:

  • Both incorporate interest rates.
  • APRs are used primarily as a borrower’s lens to view the real cost of a loan or other debt.
  • APYs are used primarily as an investor’s lens to view the actual yield of an investment. 

 

That difference in purpose of APRs vs APYs leads to their other main differences:

  • APRs incorporate a loan’s interest rate charge, fees and any other “fine print” costs and express it all as an annual percentage of the loan’s principal—the amount you borrowed. You can see those ancillary costs captured in the APR formula below.
APR/APY
  • APYs show the impact on your investment of compounding interest—in other words, your investment’s true yield. The APY formula is a variation on the compound interest formula. 

 

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.

 

Back to Basics: What is an Interest Rate?

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:

  • APRs always use simple interest, in which you multiply the principal (P) times the nominal interest rate (I) times however many years the loan will be outstanding (T).1
  • APYs always use compound interest, which computes interest on the outstanding principal and on any interest that was not paid during the previous compounding period—generating “interest on interest.”2

 

Understanding APR

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:

  • Origination fees
  • Closing costs
  • Monthly maintenance fees
  • Guarantee fees
  • Check processing fees

 

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.”

 

How is APY Different than APR for Borrowing?

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.

  • Because APY uses compounding to calculate interest charges while APR uses the simple interest method, the more frequently interest compounds (for example, daily versus weekly), the greater the difference in accumulated interest between APY and APR.
  • If you’re comparing loans with different compounding frequencies, APY may be more meaningful than APR.
  • APY does not include the “fine print” borrowing fees that APR does. For that reason, APY is best used to compare no-fee (or low-fee) loans, such as credit cards.3
  • For mortgages, that typically have significant fees, APR may be more useful for comparison.
  • If interest is compounded once annually and there are no borrowing fees, the APY and APR are the same.4

 

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.

APR/APY

 

What’s the Difference Between APR and APY for Investing?

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:

  • Investment A pays 10% semiannually.
  • Investment B pays 10.2% annually.
  • Using APR, it looks like Investment B would be a better investment because 10.2% is higher than 10%.
  • But the impact of compounding yields an APY of 10.25% for Investment A, making it the better investment decision based solely on earnings.5

 

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

 

The Takeaway

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.

Kristina Russo

Kristina Russo is a CPA and MBA with over 20 years of business experience in firms of all sizes and across several industries, including media and publishing, entertainment, retail, and manufacturing.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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