APR vs. APY: What's the Difference?

Have you ever looked at a credit card statement or a savings account offer and wondered what all those letters mean? APR, APY – they might seem like just random letters, but understanding them can save you money and help you make smarter choices with your cash. 

In this blog post, we'll break down what APR and APY mean, how they work, and why knowing the difference matters for your wallet. 

What is APR?

APR represents the Annual Percentage Rate, and it’s basically the yearly cost of borrowing money. When you take out a loan or use a credit card, the APR tells you how much extra you'll pay beyond the amount you borrowed.

APR includes both the interest rate and certain fees that are part of the loan. This makes it more accurate than just looking at the interest rate alone. When someone talks about the "rate" on a loan, they're usually talking about the APR.

There are two main types of APR:

• Fixed APR: 

With this option, your rate stays the same throughout the life of your loan. If you start with 5% APR, it will remain 5% (unless specific conditions change). The benefit of this option is that it makes your payments predictable, and you'll know how much interest you'll pay, which is usually easier to budget for.

• Variable APR: 

This rate can change over time based on market conditions. It might start at 5% but could go up or down later. This makes your payments less predictable because how much interest you pay can change, but it also has a chance of being “cheaper” if your rate goes down.

What is APY?

APY stands for Annual Percentage Yield. While APR is about what you pay to borrow, APY is about what you earn when you save or invest.

The big difference is that APY includes compound interest. Compound interest is like interest on your interest – it's extra money that grows on top of both your original deposit and any interest you've already earned.

You'll see APY advertised for:

• Savings accounts

• Certificates of deposit (CDs)

• Money market accounts

• Investment accounts

The higher the APY, the more money your savings will earn. Also, the more often your money compounds (daily, monthly, quarterly), the more you'll earn over time.

APR vs. APY: Key Differences

Here's how APR and APY differ in important ways:

• Purpose: APR is for borrowing money; APY is for saving or investing money.

• Compounding: APR doesn't account for compounding; APY does.

• Marketing: Lenders highlight APR because it looks lower (which seems better for borrowers); banks promote APY because it looks higher (which seems better for savers).

• What to look for: When borrowing, look for a lower APR; when saving, look for a higher APY.

APR vs. APY: Real-World Examples

Let's see how this works with real numbers:

Example 1: Credit Card (APR)

• Credit card with 18% annual percentage rate

• If you carry a $2,000 balance for a year

• You'll pay about $360 in interest ($2,000 × 0.18)

Example 2: Savings Account (APY)

• Savings account with 2% APY, compounding daily

• If you deposit $2,000 for a year

• You'll earn about $40.40 in interest (slightly more than the simple 2% interest of $40)

The difference might seem small in the savings example, but with larger amounts and longer time periods, it can add up. With $10,000 over 10 years, the difference between simple interest and compound interest could be hundreds or even thousands of dollars.

The Borrower's Perspective

If you're borrowing money, here's what you should know about the annual percentage rate:

• Lower is better: Always look for the lowest APR you can qualify for.

• Your credit score matters: People with higher credit scores usually get offered lower APRs.

• Watch out for introductory rates: Some loans or credit cards start with a low "teaser" APR that increases later. This is why it’s so important to read the terms & conditions.

• Fees can hide in the APR: Some loans have fees that aren't included in the APR, like late payment fees.

• Fixed vs. Variable: Remember that fixed APRs are more predictable, while variable APRs might start lower but could increase.

The Saver's Perspective

If you're saving or investing money, here's what you should know about APY:

• Higher is better: Look for accounts with the highest APY you can find.

• Compounding frequency matters: More frequent compounding (daily vs. monthly) will give you a better APY.

• Watch for minimum balances: Some high-APY accounts require you to keep a minimum amount in the account.

• Online banks often offer higher APYs: Since they have lower costs, online banks can sometimes offer better rates.

• APY can change: Banks can change their APY as market conditions change.

What's a Good APR and APY?

What counts as "good" depends on economic conditions, your credit score, and the type of product:

Good APRs (lower is always better):

• Credit cards: Below 15%

• Mortgages: Below 5% (as of early 2023)

• Car loans: Below 6%

• Personal loans: Below 10%

Good APYs (higher is better):

• Savings accounts: Above 1.5%

• CDs: Above 2%

• Money market accounts: Above 1.5%

Remember, these numbers change based on the economy. What's "good" today might be different next year.

The Bottom Line

Understanding the basic difference between APR vs. APY helps you make smarter money decisions. So, remember these key points:

• When borrowing money, focus on APR – lower is better.

• When saving money, focus on APY – higher is better.

• Remember that APY includes compound interest, which can significantly increase your savings over time.

• Don't just look at the big number in the advertisement – understand what it really means for your finances.

By knowing these terms, you can better compare financial products, avoid paying too much when borrowing, and earn more when saving. These small differences can add up to big changes in your financial future over time.

Next time you see APR or APY, you'll know exactly what it means and how it affects your money. That knowledge puts you ahead of many who don't understand these important financial terms!