Difference Between APY & APR

APY and APR can be intentionally manipulated in advertisements to make a loan look cheap or an investment look promising. APY, annual percentage yield, is a measure of interest compounded over a 12-month period. APR, annual percentage rate, is also a measure of interest, but it only accounts for the monthly period rate. This can be confusing for consumers, but broken down, you will begin to understand why banks may choose to advertise one over the other.

When APR is More Expensive than It Seems

First, consider a scenario where APR may be used by a bank to make a loan look less expensive. Consider an annual percentage rate of 15% on a credit card. This means each year you will pay 15% extra on all purchases you made with the card when you carry the balance. Divide this interest by 12, and you will learn you are paying 1.25% interest rate each month; this is called the period rate.

However, the interest is actually compounded over the year. This means you have to use the formula you may have learned in a math class years ago to find the actual APY:

APY = (1 + period rate) ^ (periods per year) – 1

In this example, we would have the following:

APY = (1 + .0125) ^ (12) - 1 or  APY = 16.1%

When a lender wants a loan to seem less expensive than it really is, the lender may express the loan in terms of APR. However, it is important to keep in mind you need to compound the interest to find out the exact cost of the loan.

When APY is Less Advantageous than it Seems

Similarly, an investment manager may list the rate of return on an investment in terms of APY to make it seem more profitable. This is not a problem unless you are comparing it with another opportunity listed in APR, then you need to make sure you are comparing apples to apples. 

Explore a situation where you are considering a CD from a bank at 5% APY against a government bond at 4.8% APR. You will need to convert the government bond to APY to determine how it really compares.

APY = (1 + .004) ^ (12) - 1 or APY = 4.9%

In this instance you would still be better off going with the CD. However, if the government was offering 4.9% APR, you would have a different outcome.

APY = (1 + .004083) ^ (12) - 1 or APY = 5.01%

If the investment is large, this .01% will make a big difference over the course of the year.

How to Use APR vs. APY

Neither measurement is "right" or "wrong." The important thing to remember is you need to make sure you are comparing two loans or investments in the same measurement. Banks and investment houses will always choose the measure that makes their offer seem more appealing. Instead of falling for this trick, convert the APR to APY or vice versa in order to make sure you are getting the best deal on the market. 

 


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