Understanding APR and APY

Ever notice that interest rates on loans are expressed in Annual Percentage Rate (APR) while interest rates of savings deposits is expressed in Annual Percentage Yield (APY)? It’s all because of marketing. If you have a loan or a deposit with a specific rate, the APR will always be smaller than the APY. Loans want to look the cheapest, so they use the smaller of the two. Deposits want to look better, so they use the larger of the two.

They differ because of compounding. When you deposit funds into a savings account, you earn interest every month (or day, depending on compounding frequency). The interest you earn each month will itself earn interest in subsequent months, thus your interest compounds. When you know the APY of a particular deposit, such as on a high yield savings account, you can calculate how much money you expect the account to hold after one year assuming no additional deposits or withdrawals.

If you wanted to know how much your balance is increasing each month, then you’ll need to calculate the APR and divide by twelve (it’s also an annual figure assuming simple interest and you can use an APY to APR calculator). It’s a smaller number because it doesn’t account for compounding, which in a way makes more sense for loans since they decrease in value as you pay them off, and why loans enjoy using it as an expression of its interest rate.

When you compare interest rates on savings account, always compare APY. APY takes into account compounding frequency, which can vary anywhere from monthly to continuously, and it gives you the most accurate basis for comparison. With loans, comparing APR is important but remember that APR does not take into account all the “other” costs associate with a loans like underwriting and origination fees.

Jim writes about personal finance at Bargaineering.com.

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  1. Randell says:

    “With loans, comparing APR is important but remember that APR does not take into account all the “other” costs associate with a loans like underwriting and origination fees.”

    Sorry, but that is just wrong. The truth in lending statement MUST include all costs associated with borrowing and will always be equal to, or higher than your rate.

    “Annual percentage rate:
    The annual percentage rate (APR) is the “cost of credit” or the amount you will pay for the credit provided to you through the loan. APR is calculated at a yearly rate. It includes not only your contractual interest rate, but also any prepaid finance charges paid during or before the loan’s closing – such as origination points, service fees or credit fees, commitment or discount fees, buyer’s points, finder’s feels, etc. – as well as any private mortgage insurance (PMI). PMI is generally required if you put less than 20 percent down on a home. Note that the APR shown on the TIL disclosure statement always exceeds the quoted interest rate because of the additional items noted above. In essence the APR reflects the true cost of your loan.”

    Taken from lendingtree,.com, but readily available elsewhere.

    • Loias supports harsher punishments against corporations says:

      APR does not include any costs not part of the interest accrued on the loan. It is, by definition, just a number that explains how much you accrue in interest on your loan.

      However, when closing costs and origination costs are tied into your loan and not paid up front, then you will be paying interest on those costs. The reason Lending Tree says those costs are part of your loan is because they assume you are using the loan to pay for them, which is common but not necessary. Lending Tree is NOT saying that APR has anything to do with closing costs. Also, Lending Tree is a gimmick, not a bank, and you shouldn’t take anything they say at face value.

      You are, in fact, wrong. Clearly you don’t understand APR or APY at all.

  2. Fantoche_de_Chaussette says:

    If this article is correct, than there are some serious regulatory changes needed here. I’d always assumed that APR stood for “Annualized Percentage Rate”, and that it included the effects of the contractual compounding period. Now, this article seems to be telling me that a 5% APR with a weekly compounding is different than a 5% APR with a monthly compounding, and that the term these advertisers should be using (in a country with a sane regulatory environment) is actually APY.

    If true, this is another disgusting example of how our “consumer” regulation comes with bought-and-paid-for loopholes you could drive a truck through.

    • mac-phisto says:

      i think you’re misunderstanding something. FIs are required to disclose APY & this is how you determine which account has a higher yield (& better compounding). if FI1 offers a CD w/ a 5%APR & a 5%APY, that means the dividends don’t compound – they are applied once at maturity. if FI2 offers a CD w/ a 5%APR but dividends are compounded monthly, then the APY will be about 5.12%. all FIs are required to disclose that APY (they aren’t required to advertise APR).

      simply multiplying the balance by the APY gives you the ability to determine a year’s worth of dividends with compounding already factored in. so, a $10,000 CD w/ an APY of 5% would earn $500 in interest in 1-year. a $10,000 CD w/ an APY of 5.12% would earn $512. that extra $12 reflects the effects of compounding.

      this isn’t a loophole, this is designed to allow you to shop the best rate most efficiently.

  3. Megalomania says:

    Where can you get an account that offers continuous compounding of interest? I ask mainly because I’d love to see the disclaimers on any of their account balance statements about how by the time you see a number, it’s no longer the correct number. Would be an awfully fun programming problem though.

  4. nickmark says:

    When you get a loan especially for a house they forgot to mention all the other fees which can
    cause heart failure.

    loan origination
    closing cost
    title insurance
    escrow account for taxes
    home owners insurance
    etc etc.
    It also depends how much you put down.
    and if loan is insured etc.
    when you figure that $100.000 loan thats advertised at only $500 month thats just the money not all the other stuff that goes with it..
    figure another $400.00 for what your real mortgage payment will actually be.
    the real cost $900-1500 by time your done

    • Randell says:

      Not necessarily. Taxes are not a function of your mortgage. It is a function of where you live. There is no way a mortgage company can or should mention those numbers. You are not required by law to have your taxes in escrow. Your home owners insurance is completely separate entity. Adding these into a housing cost is like adding utilities into the equation. They have nothing to do with your loan.

      • catastrophegirl chooses not to fly says:

        depends on the loan and the lender. my credit union’s first time home buyer’s mortgage [which i got] includes the taxes because the lender doesn’t want the house at risk for unpaid taxes. part of the low rate on the loan is the condition that homeowner’s insurance and taxes go into escrow with the bank and they pay them annually so their investment isn’t screwed up by a negligent borrower

        • wrjohnston91283 says:

          That still doesn’t make taxes and insurance part of the loan. It’s part of the payment, but not the cost of borrowing the money, like loan origination fees or points. It doesn’t go TO the lender, but is just being passed through.

    • wrjohnston91283 says:

      I know! I just found out that I need to put gas in my car each week or else it stops running.

      There should be a law…

  5. sjb says:

    Forgot to say the interest rate of 10%

    • sjb says:

      It ate my previous post so this one makes no sense and do not feel like redoing the post again.

  6. g051051 says:

    What the heck is this silly thing? Get Consumerist back on track, please, and leave off the opinion pieces, please.

  7. ssnseawolf says:

    APR: You’re paying a loan.

    APY: You’re earning interest.

  8. Mr. Elearn says:

    Easy way to convert from APR to APY:

    APY = (1+(r/m))^m

    r = nominal interest rate per year (APR)
    m = number of compounding periods per year.

  9. duffbeer703 says:

    Tips like this are ridiculous, as the spreads between APR and APY are so trivially small as to not matter. All APY does is normalize the time period so that you can compare two accounts with marginal differences between them.

    Whether an account is a good deal or not depends on a number of factors, including the type of account, how you fund it and the fees involved. APR/APY is pretty low down the list IMO.

    • Loias supports harsher punishments against corporations says:

      When numbers get higher, this is an important distinction.