APY vs. APR: How They Work, What's the Difference & What They Mean For You
APY vs. APR: How They Work, What’s the Difference & What They Mean For You
Your stomach drops.
Sweaty hands clasp and unclasp in your lap.
It suddenly feels like a thousand eyes are all on you.
Chris B. Harrison has just asked you the million dollar question: What is APY?
Your vision blurs and everything runs together, his white shirt blending with his white teeth. You wonder if any teeth should be that white? Chaos raves in your head, because your worst nightmare is unfolding.
Dizzy, reeling, and still not totally convinced that Chris B. Harrison is a real human man with real teeth, you reply: I don’t know. I don’t actually know what APY is.
Up until recently, I loosely understood what APY and APR stood for, but I wouldn’t have been able to explain it had I been put on the spot. And I know I’m not alone.
There are a number of Confusing Money Terms That We Pretend to Know But Don’t Actually Understand, and I’m doing my best to learn them and translate them in a way that everyone can understand — not just people with advanced economic degrees. That way, we won’t have to feel so embarrassingly daft if we ever get asked to play on “Who Wants to Be a Millionaire?” — or, you know, just open a savings account.
Why does money talk have to be so boring?
There are few things that make my eyes glaze over quite like banking acronyms. A lot of the jargon is pointless and won’t impact you in the long run, but there are a handful of terms that affect you and your money on a daily basis.
And as mind-numbing as this topic can be, I tend to perk up and pay attention when it comes to something that affects me and my money.
One such acronym is APY.
What is APY?
APY is short for annual percentage yield.
And that means pretty much what it sounds like: the earnings your money can yield in a year just from staying put in that account.
APY is a solid indicator of how much your account could earn — think of it as the account’s rate of return. Note that sometimes, this term is called effective annual rate (EAR). I’ve never actually come across that in real life, but it’s good to be aware so that banks don’t try to pull a fast one on you.
APY is calculated with consideration to the amount of interest paid to your account and the frequency of compounding interest.
Wait, what does compound interest mean again?
Quick reminder: Compound interest includes the interest you earn on your principal (the initial amount of money you put in the account) PLUS the interest on your earnings. The more interest* your account earns, the more interest you’ll earn ON TOP OF that. It’s like a giant snowball of money awesomeness that builds on itself.
Say I open a new savings account make a principal investment of $100. If my interest rate was 1%, I’d have a total of $101 at the end of the year. It earned one dollar.
Then the next year, assuming I left the money in the account and the rate was locked in, I’d earn 1% on $101 (a higher starting number than the year before). At the end of that year, I’d have $102.01. Over the years, compounding interest allows me to earn money by simply leaving it alone.
See? Your initial investment has a money baby (interest). And then your initial investment AND your money baby have their own money babies. Then, your initial investment AND your first money baby and all subsequent money babies each reproduce again. That’s compound interest.
You end up with a lot of money babies.
*Why is it called compounding interest and not interesting?!
Of course, these are crude examples, but you get the idea.
Imagine what happens when your initial investment is more like $20,000 and the interest rate is 5%, or there’s a higher frequency of compounding periods. (Generally, the higher the number of compounding periods, the greater the amount of compound interest you’ll earn.)
Do you see why Einstein called it the eighth wonder of the world?
So, back to APY:
Essentially, APY considers several factors, including compound interest, and gives a zoomed-out view of what your money could earn in a year — all in one handy dandy number.
Note that the APY assumes you do not add or withdraw funds for the entire year. And in accounts where you would be earning APY, you likely wouldn’t be withdrawing frequently.
What kind of accounts use APY?
Technically, APY is just a standard measure/calculation of the rate of return an investment will earn over a particular time period. So it can apply to a wide range of investments and account types.
But what you’ve likely already encountered — what you’re going to keep an eagle eye out for — is the APY on your high-yield savings accounts.
I’m talking accounts like:
CDs
Savings
Money Market
For accounts like these where your money is largely untouched on a month-to-month basis, the APY actually matters.
How to calculate APY:
If you are a total nerd good with numbers and want to do the math for yourself, first of all, I can’t even PRETEND to relate to you.
Seriously, what was it like to not cry when you had to do algebra?! I would rather write you a 10,000 word paper on why I shouldn’t complete a calculus equation than complete the calculus equation. But anyway.
Second of all, whiz kid, here is the basic formula to calculate APY:
r = interest rate
n = number of compounding periods per year (12 for monthly compounding, 365 for daily compounding, etc.)
You can figure out APY in Excel, if you, like, really want to. (But why?)
I’ve found this explained on several different sites across the internet, but I think Ally does the best job laying it out.
This is a straight-up screengrab from the Ally site because I think it’s helpful. I’m not claiming this as my own idea, though my loyal readers know I do love to come up with original math theorems in my spare time.
It’s just classic SC.
For all my fellow Communication majors out there, use an online calculator:
If you, like me, would rather sit through two hours of static TV noise in a white room than be bothered to do a math problem, there are a number of online calculators available on the interwebs. Magical times we’re living in. The two I’ve included above are just some of the most trusted/used. And, Bankrate’s calculator incorporates product- and bank- specific rates, which is pretty nifty.
Why is APY important?
APY indicates how much the money in your account could earn through interest and compounding. That means there is “free” money on the line**. That’s why it’s important.
You should want that number to be high. The higher the APY number, the faster that your account will grow and continue to build upon itself.
The good news is that banks are obligated to display their APY numbers, which means you can easily compare accounts and know that there’s not some hidden, nuanced element you’re not seeing.
If you’re looking for a horribly punny way to remember what to look for when comparing APY and APR, here’s a little diddy for you:
It goes without saying that this groundbreaking mnemonic device is intended to be sung to the tune of the iconic 1999 hit single from Tal Bachman, “She’s So High.” Because honestly, if your financial advice isn’t sung to the tunes of a 90s classic, what is even the point?!
**“Free” in quotation marks because you aren’t really getting money for free; you’re letting the bank borrow from you with the understanding they’ll pay you back with a small additional fee. That’s interest.
What is APR?
APR is an acronym for annual percentage rate.
Instead of indicating how much money your account will yield (as APY does), APR indicates the total amount of interest you must pay on a loan, like an auto loan or a credit card, over one year.
APR is based on the interest rate, but for some loans, it also takes into account points, additional fees, and other associated loan costs. Or, if it’s the APR on a mortgage, the APR may consider closing costs or insurance. Even between different credit cards from the same company, the APR can vary depending on the type of transaction you make with the card.
How is APY different than APR?
Unlike APY, APR does NOT consider the frequency of compounding interest.
Which means that when you look at an advertised APR, you’re not getting the whole story. Without knowing how often the bank compounds the interest on your loan, you can’t easily compare loans. It’s important that you understand the compounding frequency before you sign on to any loan because those numbers can add up REALLY quickly.
Say, for example, you get a loan with APR of 10 percent. By exclusively considering the APR, you can’t know if you would be paying 10 percent of your balance at the end of the year or 0.83 percent once every month (which is 10% divided by 12, for 12 months). And it’s a significant difference because the more frequently the interest is compounded, the higher amount you’ll pay in total.
See how lenders might want to keep this confusing?
What does APY or APR actually mean for me?
With APY, your earning potential is at risk.
APY gives you the most accurate idea of the amount of money your account can grow in the span of one year, so it does matter to pay attention to this number. Although the small percentage numbers may seem inconsequential, they can make a big difference in the amount of money you earn and save in your account.
With APR, your savings potential is at risk.
Find out exactly what’s included in the advertised APR, because it might not be painting the full picture. The various elements for each loan or credit card are different, but the gist is that the higher the APR, the more interest you will pay.
Think of it this way: Compound interest is at work in both APY and APR.
With APY, the more frequently the interest compounds, the more money you will earn. And it’s the total opposite for APR — the higher the compounding rate, the more money the OTHER GUY makes off of you.
Compound interest is powerful and can build up quickly, so you want to make sure it’s working for you — not the other way around!
TL;DR:
APY = Money your account EARNS
APR = the interest you PAY on a loan
Quick recap of APY vs. APR:
APY, or annual percentage yield, is the rate of return that your account will yield in one year.
It indicates what you earn.
The higher the number, the more interest your account earns.
Because APY includes the frequency of compounding interest, you can compare various accounts’ APY and know you are measuring apples to apples.
APR, or annual percentage rate, is the amount of interest you must pay on a loan over one year.
It indicates what you will pay on top of the money you borrow.
The lower the number, the less interest you will pay overall.
APR does not consider compounding frequency, so you can’t get the full picture until you ask what that is.
And now you know what APY and APR mean. Take that, Chris B. Harrison.
Have you ever had an “Oh, omg, I really don’t know what that means” moment where you felt money-shamed or inadequate? You know, where you nod during the conversation and casually Google a term under the dinner table?! Please make me feel better — drop me a comment and share your story!
Want to get a leg up on other confusing money terms?
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