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.