Financial Literacy Series: Knowing the difference between APR and APY
When it comes to calculating interest rates, there are two methods: Annual Percentage Rate (APR) and Annual Percentage Yield (APY). At face value, a low APR can be appealing if you’re borrowing. However, since ARP doesn’t consider compound interest, it may not include all the data you need to make an informed financial decision. If available, APY can help you to understand the effects of compound interest on your money.
Once you understand the difference between the two acronyms, you can improve your money management and financial health. Here’s a quick tip though: APR is more often applicable to lending products, and APY tends to be more in reference to savings and investment accounts. Here’s how APR and APY break down:
APR: How annual percentage rate is calculated
APR is simple interest that is calculated over a year’s time. In most cases, it’s used to refer to interest on loans or credit cards.
For example, let’s say you’re buying a new computer that costs $1,000. You charge it to your credit card that has an interest rate of 22% APR. That works out to $220 in interest for the year or $18.33 per month.
“APR refers to the total interest rate, fees, and other loan costs. It does not include any compound interest,” says Robb Engen, a fee-only planner at Boomer & Echo. “Relying strictly on the APR could be misleading in terms of the true cost of borrowing.”
APY: How annual percentage yield is calculated
“Interest on interest” is known as compound interest. There’s also a compounding period (e.g., annually, semi-annually, etc.) that needs to be considered. With APY, compounding is factored in, which is why it’s a more accurate way of seeing how much you’re paying or saving.
“Compound interest works against you when borrowing since interest gets added on top of the total outstanding interest—which increases the cost of borrowing,” says Engen. “When it comes to saving, comparing the APY rate on savings accounts will help you determine the best deal.”
For example, mortgages in Canada are compounded semi-annually. That means accrued interest is applied to the unpaid balance twice per year. Imagine a $400,000 loan that comes with a 5% interest rate. Most people would assume the APR rate is 5%, when you factor in compounding, the real rate you’ll pay is 5.063%.
APR vs. APY by the numbers
Now that you know how APR and APY work, let’s look at a few examples in practical terms. Let’s say you invest $10,000 into a savings account that pays 5% interest annually over three years. Many people would look strictly at the APR of $500 per year, which would give them $11,500 after three years. But as you’ve learned, APY is the more accurate calculation.
Here’s a side by side comparing of APR vs APY:
| Years | APR | APY |
|---|---|---|
| End of year 1 | $10,500 | $10,500 |
| End of year 2 | $11,00 | $11,025 |
| End of year 3 | $11,500 | $11,576.23 |
As you can see, once the APY is calculated, you’ll walk away with $11,576.25 after three years. That’s $76.25 more than what the APR calculation is.
Knowing the difference between APR and APY is also important when considering a loan. Using a payday lending scenario for purposes of example, let’s say you’re offered $300 for two weeks at a fee of $69. Since you’re paying $23 in interest for each $100 you’re borrowing, at face value, it looks like 23% interest for 14 days.
That may seem reasonable, but you need to include the compounding periods into your calculation. There are 365 days in a year, if you divide that by 14 days (which is the compounding period for this loan), you get 26.0714 periods. Take that number and multiply it by 23% interest and you get 599.64% interest. That’s a steep price to pay for a short-term loan.
Always read the fine print
All loans are required to display their APR to show the interest rate, plus any fees and charges. It’s important to remember that APR doesn’t account for compound interest. A complete understanding of your financial health should involve knowledge of how compounding interest affects your loan. When it comes to savings deposits, however, it’s more likely that the APY will be displayed since it’s something savers will look for.
If you’re interested in financing, whether it be a personal loan, auto financing, or a mortgage, reach out to Coast Capital’s Lending Team to go over your options and explain how much interest you’ll be paying in all scenarios. The answers could be eye-opening.
