Both APR (annual percentage rate) and APY (annual percentage yield) are commonly used to reflect the interest rate paid on something, but what is the difference between the two? Understanding the difference will help you understand exactly how hard your money is working for you.
It’s All About Compounding
APR simply reflects the annual interest rate that is paid on an investment, but doesn’t take into effect how interest is applied. APY takes into account how often the interest is applied to the balance, which can range anywhere from daily to annually.
For example, let’s say you deposit $10,000 into an account that has an APR of 5%. If interest is only applied once per year, you would earn $500 in interest after one year.
On the other hand, let’s say that interest is applied to the balance monthly. This means that the 5% APR will be broken down into twelve smaller interest payments for each month, or in this case around 0.42% per month. Using this method, your $10,000 deposit will actually earn $42 in interest after the first month. That means in the second month, 0.42% will be applied to the new balance of $10,042, and so on.
In this example, even though the APR is 5%, if interest is compounded once a month, you would actually see almost $512 of earned interest after one year. That means the APY turns out to be around 5.12%, which is the actual amount of interest you’ll earn if you hold the investment for one year.
Always Compare APY to APY
When shopping for a new savings account, CD, or money market, make sure that you are comparing apples to apples. That means when you are considering interest rates, you’re comparing APY to APY. If you are comparing one account advertising its APR with another’s APY, the numbers may not reflect which account is better. When comparing the APY of both, you have a clear picture that shows which account will yield more interest.