APR vs. APY: The Basics
These two acronyms look similar but represent fundamentally different things:
APR (Annual Percentage Rate) is the simple interest rate charged or earned over a year, without accounting for compounding.
APY (Annual Percentage Yield) includes the effect of compound interest, showing you the true amount you will earn or owe over a year.
How Compounding Changes Everything
The key difference is compounding — earning interest on your interest. The more frequently interest compounds, the larger the gap between APR and APY.
Example: $10,000 at 5% for One Year
| Compounding Frequency | APR | Effective APY | Year-End Balance |
|---|---|---|---|
| Annual | 5.00% | 5.00% | $10,500.00 |
| Monthly | 5.00% | 5.12% | $10,511.62 |
| Daily | 5.00% | 5.13% | $10,512.67 |
The formula: APY = (1 + APR/n)^n - 1, where n is the number of compounding periods per year.
When Each Rate Matters
Use APY When Saving
When comparing savings accounts, CDs, or money market accounts, always compare APY. This tells you exactly how much you will earn. A savings account advertising 4.90% APY will earn you more than one advertising 5.00% APR compounded annually.
Use APR When Borrowing
For loans, credit cards, and mortgages, APR is the standard disclosure rate. However, be aware that credit card APR compounds daily, so the effective cost is higher than the stated APR.
Real-World Applications
Credit cards: A card with 24% APR compounding daily has an effective APY of 26.82%. On a $5,000 balance, that is an extra $141 per year in interest.
Savings accounts: An account advertising 5.00% APY with daily compounding has an APR of approximately 4.88%. The APY already accounts for compounding, so it is the more useful number.
Mortgages: A 30-year mortgage at 6.5% APR with monthly payments has an effective APY of 6.70%. Over the life of a $300,000 loan, this difference amounts to thousands of dollars.
Key Takeaways
- APY includes compounding; APR does not
- For savings, compare APY to see your true earnings
- For borrowing, understand that the true cost often exceeds the stated APR
- More frequent compounding increases the gap between APR and APY
- Always ask which rate is being quoted and how often interest compounds