Introduction
When you take out a loan or open a savings account, you will inevitably see two acronyms: APR and APY. While they both relate to interest, they are calculated differently and serve different purposes. Knowing the difference can save you thousands of dollars over your lifetime.
The Key Differences at a Glance
| Feature | APR (Annual Percentage Rate) | APY (Annual Percentage Yield) |
|---|---|---|
| What it stands for | Annual Percentage Rate | Annual Percentage Yield |
| Includes Compounding? | No | Yes |
| Best used for | Borrowing money (Loans, Credit Cards) | Saving money (Savings Accounts, CDs) |
| What Banks Advertise | The lower number (makes debt look cheaper) | The higher number (makes returns look better) |
What is APR in Detail?
APR represents the annualized cost of borrowing money. It includes the simple interest rate plus any mandatory fees charged by the lender. However, it does not take into account how frequently that interest compounds during the year.
If you have a credit card with an APR of 20%, you will actually pay more than 20% over the course of a year if you carry a balance, because the card compounds interest daily.
What is APY in Detail?
APY is the true rate of return earned on an investment (or paid on a debt) over a year, taking into account the effect of compounding interest.
Because compounding means earning "interest on your interest," the APY will always be equal to or greater than the APR. For savings accounts, a higher compounding frequency (like daily instead of monthly) will result in a higher APY.
Calculate your Compound Interest here →
How Banks Use Both to Their Advantage
Banks are legally required to disclose both rates, but they heavily market the one that looks most appealing:
- When you borrow: They highlight the APR because it is the lower number, making the loan seem cheaper.
- When you save: They highlight the APY because it is the higher number, making the savings account seem more lucrative.
Summary
The golden rule of personal finance: Look at APR when borrowing, and look at APY when saving. This ensures you are looking at the most accurate representation of what the money will cost you, or what it will earn you.