The confusion between APR and APY is easily explicable. Both are utilized to compute investment and credit product interest rates. When they are applied to account balances, they have a significant impact on how much you earn or must pay.

The Difference Between APR and APY

APR and APY may sound identical, but they are distinct and not created equal. APY, or annual percentage yield, takes compound interest into account, whereas APR, which stands for annual percentage rate, does not.

APR is the annual rate charged for the earning or borrowing money. APY takes compounding into account, whereas APR does not.

Whenever there is a larger  difference between the  APR and APY, the greater will be the frequency of interest compounding.

Investment firms typically promote the APY, whereas lenders promote the APR.

Understanding Compound Interest

According to reports, Albert Einstein referred to compound interest as humanity's greatest innovation. Whether you agree or disagree, it is essential to comprehend the application of compound interest to investments and loans.

Compounding refers, at its most fundamental level, to the process of earning or paying interest on previously accrued interest, which is added to the principal amount of a deposit or loan.

Most loans and investments calculate interest using a compound interest rate. Every investor desires to maximize compounding on their investments while minimizing it on their loans. Simple interest is the result of multiplying the daily interest rate by the number of days between payments, whereas compound interest is the result of multiplying the everyday interest rate by number of days between the payments.

Compounding is crucial to understanding APR and APY because many financial institutions quote interest rates in a sneaky manner that takes advantage of compounding principles. Being financially literate in this area can help you determine the actual interest rate.

APR

Since it appears that borrowers pay less in the long run for accounts like loans, mortgages, and credit cards, financial institutions frequently promote their credit products using APR.

APR does not account for the compounding of interest over the course of a year. It is computed by multiplying the periodic interest rate by the number of periods per year for which the periodic rate applies. It does not specify the number of times the interest rate is applied to the balance.

The APR is determined as follows:

Annual Percentage Rate = Periodic Rate x Number of Periods per Year

APY

The annual percentage yield (APY) is typically advertised by investment firms to entice investors by making it appear that they will earn more on items such as certificates of deposit (CDs), individual retirement accounts (IRAs), and savings accounts. Unlike APR, APY accounts for the frequency with which interest is applied, or the intra-year compounding effect. This seemingly minor distinction can have significant repercussions for investors and borrowers. The annual percentage yield (APY) is calculated by adding 1 plus the periodic rate as a decimal, multiplying it by the number of times equal to the number of periods that the rate is applied, and then subtracting 1.

Here is how the APY is computed:

APY = (1 + Periodic Rate)

APR versus APY based on the number of periods – 1 Example

A credit card company may charge 1% monthly interest. Therefore, the APR is 13% (1 % multiplied by 12 months = 13%). This is distinct from the APY, which accounts for compound interest.

Annual percentage yield for a 1% interest rate compounded monthly would be 12.68% [(1 + 0.01)12 - 1 = 12.68%]. If you carry a balance on your credit card for only one month, you will be charged the equivalent of 12% annually. However, if you carry that balance throughout the year, your effective interest rate increases to 12.68% due to monthly compounding.

The Truth in Lending Act (TILA) requires lenders to reveal the APR charged to borrowers. Credit card companies are permitted to advertise monthly interest rates, but they must disclose the APR before customers sign an agreement.

The Borrower's Perspective

As a borrower, you always seek the lowest possible interest rate. When considering the difference between APR and APY, you should be wary of loans that are disguised as having a lower rate. APY is also known as earned annual interest (EAR), which accounts for compound interest.

When shopping for a mortgage, for instance, you are likely to select the lender with the lowest interest rate. Although the quoted rates appear to be low, you may end up paying more than anticipated for a loan.

This is due to the fact that banks frequently quote the annual percentage rate on loans. However, as we've already stated, this figure does not account for any semi-annual, quarterly, or monthly intra-year compounding of the loan. The APR is calculated by multiplying the periodic rate of interest by the number of periods per year. This may initially be a bit confusing, so let's examine an example to clarify the concept.

Despite the fact that a bank may quote you a rate of 5%, 7%, or 9%, depending on the frequency of compounding, you may end up paying a significantly higher rate. If a bank quotes an APR of 9%, the figure does not take compounding into account. However, if you account for the effects of monthly compounding, as APY does, you will pay 0.38 percent more on your loan each year, which is a substantial amount if you are amortizing your loan over 25 or 30 years.

This example should illustrate the importance of inquiring about a lender's interest rate when seeking a loan.

In order to make the most informed decision, it is essential to compare apples to apples (i.e., the same types of numbers) when evaluating various borrowing opportunities.

The Lender's Perspective

As you may have already guessed, it is not difficult to comprehend how standing on the other side of the lending tree can affect your results in an equally significant manner, and how banks and other institutions frequently entice individuals by quoting annual percentage yield (APY). Those who are lending money (which you are technically doing by depositing funds in a bank) or investing funds seek the highest possible rate of return.

Suppose you are searching for a bank at which to open a savings account. Obviously, you want the one that provides the highest return on your hard-earned money. It is in the bank's best interest to quote you the annual percentage yield (APY), which includes compounding and is therefore a sexier number than the annual percentage rate (APR), which does not include compounding.

Examine the frequency of compounding and compare it to the APY offered by other banks with equivalent compounding rates. It can significantly affect the amount of interest that could accrue on your savings.

The Bottom Line

Understanding both APR and APY is essential for managing your personal finances. The greater the frequency of compounding interest, the greater the difference between APR and APY. Be mindful of the different rates quoted when shopping for a loan, applying for a credit card, or searching for the highest rate of return on a savings account.

Whether you are a borrower or a lender, financial institutions have different reasons for quoting varying interest rates. Always ensure you comprehend the quoted interest rates, and then compare them to those of other institutions. The disparity in figures may surprise you, and the lowest advertised rate for a loan may end up being the most expensive.