Most first-time borrowers often confuse APR with APY. They may sound the same but are not the same term. It is common to apprehend why many people confuse these terms. Both the acronyms are used to calculate interest for investment and credit products. Additionally, they certainly affect how much you earn or pay when they are attached to your financial dealings.
For starters, the Annual Percentage Yield takes into account compound interest, whereas the Annual Percentage Rate is the cost of borrowing money. However, both are different ways to talk about interest. For instance, if you have opened a savings account or applied for a mortgage loan or credit card, you might have come across these terms.
Compound interest was referred to as mankind’s greatest invention by the great Albert Einstein. At its most basic level, CI stands for earning or paying interest on previous interest. In other words, it refers to the addition of preceding interest and the principal sum of the deposit or loan.
Understanding the compounding process is critical to understanding APR and APY because many advances and investments use it to calculate interest.
Annual Percentage Rate allows financial institutions to tout their credit products by assuring the borrowers that they will be paying less in the long run for loans, mortgages, and credit cards.
It doesn’t take into consideration compounding within a specific year. Instead, it is calculated by multiplying the periodic interest rate by the number of periods in a year. Note that it doesn’t tell the number of times the rate is applied to the balance. It is calculated as:
APR = Periodic Rate x Number of Periods in a Year
Financial institutions use Annual Percentage Yield to attract investors. Generally, they advertise APY because it seems like they’ll earn more on things like CDs, Saving Accounts, and IRAs. It takes into account the effects of intra-year compounding or the frequency at which the interest is applied. It is calculated by adding one to the periodic rate as a decimal and multiplying it by the number of periods that rate is applied, and then finally, subtracting one from the resultant.
The Borrower’s Perspective
As per the borrowers, when looking at the difference between these acronyms, they are often worried about how a loan might be disguised as having a lower rate.
When they shop around for a mortgage, they are most likely to choose a lender who offers the lowest rate. While the quoted rates might appear appealing, they end up paying more for the advance than they originally anticipated.
This is the reason why banks often quote the annual percentage rate on loans. It is simply the periodic rate of interest multiplied by the number of periods per year.
The Lender’s Perspective
Those who are lending money, technically by depositing funds in a bank, or investing funds, seek to receive the highest possible rate of interest.
For example, you are shopping around for a bank to open a savings account and offer the best rate of return on your hard-earned dollars. Banks quote you the APY in their best interest, including compounding.
Therefore, it is crucial to look deeper into the compounding concept and how often that process repeats. Then, compare that to other banks’ APYs with compounding at the equivalent rate.
The Bottom Line
To better manage your personal finances, it is imperative to understand “what is APR or APY?” Similarly, it is conducive to acknowledge the difference between them to make a wise and profitable decision.
Financial organizations, too, have different motives for quoting distinct rates, depending upon whether you are a borrower or a lender. So, make sure which rate they are quoting and consider the comparable ones from other institutions. The difference in the numbers is sure going to surprise you.