The financial world is full of acronyms, and many of them are not always fully understood. APY is certainly among them. It is the acronym for annual percentage yield, but it is often confused with APR, short for annual percentage rate.
There are some meaningful differences between these terms, so Bottom Line Personal asked Lending Tree chief consumer finance analyst Matt Schulz what consumers need to know…
APY and APR are both measures of interest, but they’re calculated in different ways and used in different situations.
APY typically is used to express the amount of interest consumers earn from a financial product, such as the interest they are paid by a bank savings account.
APR is used to express the amount of interest consumers pay when borrowing money, such as the interest rate imposed by a credit card when customers carry balances.
APY and APR also are calculated differently. APY takes compound interest into account, while APR does not. Compound interest includes the interest earned by previously earned interest. Example: If a savings account earns 5% interest, compounded annually, the initial $100,000 in the account will be worth $105,000 at the end of Year One and $110,250 at the end of Year Two. The same interest rate earned $250 more in the second year because the interest from the first year was added to the original principal. While $250 is not a large sum in the context of a $100,000 investment, compound interest can add up to a meaningful amount in the long term. After 10 years, that same $100,000 would be worth nearly $162,900—that is $12,900 more interest than the $50,000 someone might have assumed they’d have earned if they thought to themselves, What’s 5% of 100,000, times 10 years?
Three additional details worth noting…
That’s why a loan’s APR often is not precisely the same as its interest rate. Be sure to understand which fees are and are not baked into the APR that has been quoted before signing loan documents, especially mortgages, which may have loan origination fees, discount points and insurance.
This is particularly true for borrowers who allow loan or credit card balances to increase over time rather than promptly pay them down.
The more frequently interest is added to principal, the more powerful the effect of compounding becomes, though the difference still tends not to be massive. Example: Two accounts pay 5% annual interest, but one compounds daily and the other annually. After 10 years, $1,000 invested in the former will be worth $1,649…the latter $1,629.
