What really catches your attention in an interest rate? Is it the annual percentage rate (APR) or the annual percentage yield (APY)? If you are looking for an investment or applying for a loan, it is important to understand the difference between these two terms. Here we explain how they work and how they can affect your money.
What is APR?
The APR, or annual percentage rate, is the interest rate applied to a loan or investment for a year. It is a measure of the cost of the money you lend or invest. The APR includes any additional charges or fees that may apply, such as commissions, taxes, or insurance. Typically, the APR is expressed as a percentage and is calculated by dividing the total interest you pay over a year by the principal amount of the loan or investment.
For example, if you lend $1,000 at a 10% APR interest rate for a year, you will pay $100 in interest. If you apply for a loan with a 15% APR, you will pay $150 in interest on the same principal amount. It is important to note that the APR is calculated on the principal amount, not on the outstanding balance of the loan or investment.
What is APY?
The APY, or annual percentage yield, is the interest rate applied to an investment for a year and includes the effect of compound interest. Compound interest is the interest that is generated on accumulated interest, which means that the interest accumulates on itself over time.
For example, if you invest $1,000 at a 10% APY interest rate for a year, you will earn $100 in interest. If that interest is accumulated and reinvested the following year at the same rate, you will earn $110 in interest during the second year. The APY is calculated by dividing the total interest you earn over a year by the principal amount of the investment.
What is the difference between APR and APY?
The main difference between APR and APY is the effect of compound interest. APR only measures the interest paid or charged on a loan or investment over a year, while APY includes the effect of compound interest on the accumulated interest. This means that the APY reflects the true cost of an investment over time, while the APR does not.
For example, if you invest $1,000 at a 10% APY for two years, you will earn $210 in interest. If the same investment were made at a 10% APR, you would only earn $200 in interest. The additional $10 in interest is the result of compound interest.
In summary, APR measures the cost of borrowing or lending money, while APY measures the return on an investment. It is important to understand the difference between these two terms when comparing investment or loan options, as they can have a significant impact on the amount of money you earn or pay over time.
