APR vs. APY: What's the Difference When It Comes to Interest Rates?

It’s easy to confuse APR (annual percentage rate) and APY (annual percentage yield). Both tell you how much you’ll pay or earn in interest, both are expressed as a percentage, and both express the cost or profit over the course of a 12-month period. But there is one big difference between the two: The APY accounts for compound interest while the APR does not. Because of this, the APY gives a more accurate rate of interest.

Let’s take a closer look at APR and APY to see how these two terms differ in meaning and application.

What’s the Difference Between APR and APY?

An APR is the annual percentage rate on a savings or borrowing product and represents the cost someone pays each year to borrow money; this includes fees. The APY is the “actual rate” someone earns on a balance. Essentially, the APY measures the total amount someone pays in interest while taking the frequency of compounding into account.

Borrowing or Earning Amount 

An APR reflects both the fees and interest rate associated with borrowing or earning money. The higher the APR, the more you will pay over the life of the loan. APY also determines the interest you’ll earn or pay, and takes the power of compounding interest into account.

Measurement

Both APR and APY measure interest. When divergence between the two figures occurs, it’s because APR measures the rate of interest charged on an annual basis without accounting for compounded interest. The more frequently interest is compounded, the larger the difference between APR and APY.

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While both the APY and APR can apply to credit products or deposits accounts, you’ll hear APR and APY more commonly referenced with one type of financial product over the other. APYs are used more often to advertise interest-earning accounts such as savings accounts, money market accounts, or certificates of deposit (CDs). Lenders are more likely to reference the APR when talking about credit products such as credit cards or personal loans.

Which Is Right for You?

While the APR gives a good baseline of what it will cost you to borrow money from a lender, the APY gives a much clearer picture if you were to borrow or save money on a long-term basis. The APY accounts for the actual rate someone will earn or pay in interest over time as the interest compounds. If you were to only carry a credit card balance for a month, the APR tells you what you need to know. If you plan to carry a balance for many months or years, then the APY will help you calculate how that debt will grow over time. APY is also preferable when it comes to determining how much you’ll earn over the long term in a CD or savings account.

APR vs. APY Example

To make it easier to understand how APR vs. APY works, it can be helpful to learn how their equations differ.

Let’s start with the APR on a monthly basis since this gives you an idea of what happens if compounding isn’t involved.

Monthly APR = (Interest/12 months) x Balance

For example, if you owe $1,000 on a credit card and the APR is 12%, then you will divide 12% by 12. This brings you to 1%. So $1,000 multiplied by 1% equals $10 a month in interest charges. This would be an amount of $120 a year.

To calculate your APY, you’ll use the following formula:

APY =100 x (1 + i/n)^n − 1

r = interest rate

n = number of compounding periods per year

When you plug in the same numbers in the above example, you end up with an APY of 12.68%, which means you’ll pay $126.80 in interest annually.

APY = 100 x (1 + .12/12)^12 − 1

APY = .1268% / 100 x $1,000

In this scenario you would pay $6.80 more per year in interest charges. That may not seem like a lot, but increase the interest rate and balance, and you can see why understanding your APY comes in handy.

How Interest Rate Environments Affect APR and APY

When an APR is a fixed rate, it doesn’t change over the life of the loan or savings product. However, a variable APR changes over time and is susceptible to changes in the broader interest-rate environment.

For example, when the Federal Reserve executes an interest-rate hike, it becomes more expensive to borrow money. Thus, you may see a higher APR for your credit card or auto loan and a higher APY on savings accounts and CDs.

The opposite is true as well. When interest rates are cut—as they were in March 2020 in response to the COVID-19 pandemic—APYs and APRs are lower.

Frequently Asked Questions (FAQs)