If you have ever shopped for a loan or credit card or the best rate on an interest-bearing savings account, you've certainly encountered the abbreviations APR and APY. They each represent a method of calculating interest rates. But they are different calculations. Understanding the differences between these two methods of expressing interest rates is important. Doing so helps you understand how much interest you're being charged. Here's our APR vs. APY comparison guide.
What Is Annual Percentage Rate (APR)?
The annual percentage rate, or APR, shows how much you pay. It is the annualized interest rate that you pay on a loan. The APR for a loan includes the interest rate that is being charged. But it also includes loan fees, such as an origination fee, that are not paid upfront. And the APR also includes compounding interest.
There may be several APRs shown for your loan or credit card. There may be a basic APR for the loan or the credit card. But there may also be one for a credit card balance transfer, one for cash advances on the card, and potentially one for late payments on the card or your loan.
APR can also be expressed as a fixed or a variable APR.
- A variable APR fluctuates based on a benchmark such as the prime rate. The APR fluctuation can work for you or against you depending upon the movement in the benchmark. A loan or credit card with a variable APR may start off as being less expensive than one with a fixed APR. But if the benchmark interest rate rises, the loan may get more expensive down the road. Variable APRs are very common with credit cards.
- A fixed APR doesn't change over the life of the loan. This makes things more predictable for you. Personal loans and many mortgages are examples of loans that quote fixed APRs.
What Is Annual Percentage Yield (APY)?
The annual percentage yield, or APY, shows how much you earn. It is the real rate of return that you earn on a savings account, certificate of deposit (CD), investment, or a similar account. APY takes the impact of compound interest into account. U.S. banks are required to include the APY when advertising the interest rates in interest-bearing accounts.
APY represents a truer picture of what you earn from interest-bearing savings or investment account because it includes the effect of compounding. Compound interest is essentially earning more interest on the interest that has already been credited to your account.
Online Banks With the Best APY
Online banks often offer higher APYs on savings and other deposit accounts than you find at brick-and-mortar banks. There are a number of sites that list online banks listed by the highest APY. And check out our articles on the best high-yield savings accounts and best online banks.
Dig deeper than just the number presented when reviewing any list of top APYs. Go to the bank's site and try to understand what is included in their APY for savings and other depository accounts. If you can't find the information that you need on the bank's site, don't be afraid to pick up the phone and call the bank's customer service line.
Why Is Interest Rate Different From APR?
When looking for a mortgage loan, other types of loans, or a credit card, it's important to note that the interest rate advertised by the lender is different from what the loan or credit card actually costs the borrower.
The interest is the raw cost the lender is charging you for borrowing the funds. This is expressed as a percentage and can be fixed or variable over the life of the loan. The interest rate is a good indicator of your monthly cost for the loan and can be a good metric to compare different loan alternatives at a glance. The interest rate, however, does not tell the total story of what the loan or credit card actually costs you.
This is where the APR comes in handy. The APR includes all costs of the loan, not just the interest. These costs include any broker's fee, closing costs, discount points, etc. However, the APR may not include all fees assessed to the borrower such as the cost of a property appraisal for a mortgage or the cost of a credit check on the borrower.
Illustrating the Difference Between the Interest Rate and the APR
Let's look at two examples that show the difference between the stated interest rate on a loan and the APR on that loan.
In the first example, consider a 30-year mortgage of $200,000 with a 4% interest rate and $5,000 in closing costs and 3% in origination fees. The actual APR would be 4.5% rather than the stated 4%.
For another example consider a $10,000 personal loan. The loan runs for five years with a 9% fixed interest rate. Personal loans often have an origination fee in the 2%–5% range of the loan amount. In our example, assume a 3% origination fee on the loan. This brings the loan APR to 10.3% vs. the stated 9% interest rate on the loan.
The stated interest rate is useful for looking at your monthly cost for most types of loans. But the APR tells you what the loan really costs, whether looking for a mortgage, a personal loan, or a credit card.
Make Sure You Understand the True Cost
APR and APY are very useful tools in helping you understand the true cost of a loan and the true interest rate on your savings or investment account when the benefit of compounding is added in.
APR is useful in comparing the costs of several loans in that it includes all fees associated with the loan. But be sure to understand what is and isn't included in the APR calculation.
Likewise, with APY, two savings accounts with identical interest rates may have different APYs due to differences in the frequency of interest payments and other factors. Again, be sure to understand what is included in the APY calculation.