If you look at any credit card offer online, you'll see that interest rates are listed as “APR."
Now if you visit any bank to open a savings account, you’ll see your rate of return listed as “APY."
Most people either think that they are the same thing or don’t have a clue what the difference is between the two terms.
While the face-value difference between APY and APR simply may be the last letter of the acronyms, the difference on your finances can be major. Especially at high balances, the difference will become more significant.
What is Compounding?
Before you can understand the difference between APY and APR, you should first learn the power of compounding, which was believed to be the most powerful force in the universe by Albert Einstein.
Compounding is simply the repeated accrual of interest on your principal balance. With an annual 10% interest rate on a $100 principal balance, the result would be a $110 balance in one year.
After another year, the annual 10% interest rate is added to the $110, which is technically the new principal balance. The result is a $121 balance.
With APY, you simply multiply the rate and your starting balance to find the interest yield after one year.
With APR, you will have to do a little more work to find out the annual interest.
The formula for APY is:
APY = (1 + APR/t)^t - 1
Here, 't' is the compounding period. Savings accounts usually compound their interest monthly, so 't' would be 12. Credit cards often use a daily compounding method, in which case 't' would be 365.
What is APY?
APY stands for annual percentage yield, which is the interest yielded in one year with compounding taken into account.
When a savings account offers 4.00% APY, your $1,000 balance will become $1,040 in one year. Effectively, this savings account is paying you with an APR of 3.93% (compounded monthly).
- The APY is a direct way of telling customers what their yield is on their savings.
- To see how the balance was calculated, conduct a Google search with this input: “1000*(1+4%)."
- To see how the APR was calculated from APY, search: “12*((12th root of (4%+1))-1)."
Use MyBankTracker's APY calculator to determine your projected interest earnings.
What is APR?
APR stands for annual percentage rate, which is the rate of interest in one year without compounding.
If your credit card had an interest rate of 21.99% APR, your $1,000 balance will become $1,246 in one year (compounded daily and assuming no payments were required). Effectively, your credit card is charging you the equivalent of 24.59% APY.
- The APR requires you to make calculations to find out how much you are really being charged.
- To see how the balance was calculated, do a Google search with this input: “1000*((1+(21.99%/365))^365)”."
- To see how the APY was calculated from APR, search: “((1+(21.99%/365))^365)-1."
The Math Trickery By Banks
The primary purpose of this seemingly complex mathematical and financial jargon is to deceive you, the banking customer.
One thing you may be wondering is why do banks and credit card companies advertise the APR rather than the APY equivalent in their credit card offers.
The reason for that is the fact that the APY would always be higher than APR.
Banks take advantage of the small difference because they want you to see a lower number to lure you into opening a credit card account.
On the other hand, banks advertise APY on their deposit accounts because you see the higher number compared to the lower APR.