APR vs. APY: What's the difference?

APR and APY are similar financial concepts, but they operate at opposite ends of the spectrum. An annual percentage rate (APR) is the interest and fees that accrue on a yearly basis for credit and loans. It can also refer to the cost of borrowing money to make investments. Annual percentage yield (APY) is the yearly pace at which an account with interest accumulates, taking into account compound rates. 

Both represent a percentage change in a financial account, but APR only applies to borrowers, while APY applies to lenders or savers.  

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APR is the yearly cost of borrowing money. Most commonly seen with credit cards, personal and auto loans, and mortgages, it combines the interest and fees on a loan into one percentage and standardizes costs to help you compare them across the board. However, it doesn't factor in compounding interest, so a loan with a lower APR may not be the cheaper option in the long run.

APR is typically either fixed or variable. A fixed rate is set at the start of the loan and won't change based on external circumstances, while a variable APR can shift higher or lower based on the rates set by the U.S. Federal Reserve. 

Some lenders — such as credit card companies — tell borrowers the APR outright, but it may be unclear in other situations. 

To calculate APR, follow this example:

You're buying a car for $15,000, and the loan term is 60 months. The lender is charging you 30% interest, as well as $600 in fees.

• First, add the fees and interest. $4,500 + $600 gives you $5,100. 
• Next, divide the above number by the original amount of the loan, known as the principal. $5,100/$15,000 gives you 0.34.
• Take that number and divide it by the number of days in the repayment term. 0.34/1825 equals around 0.000186.
• Multiply your result by the number of days in a year. 0.000186 x 365 gives you approximately 0.0679.
• Finally, multiply that product by 100 to turn it into a percentage. 0.0679 x 100 is 6.79, meaning your APR in this case would be 6.79%.

Picture this. Samuel has a choice between two $15,000 auto loans, and he doesn't know which one will cost more in the long run.

Loan A has a term of 60 months, and the lender is charging 30% total interest and a $600 administration fee. The APR is 6.79%.

Loan B has the same term, and the lender is charging 25% interest and a $1,500 administration fee. The APR is 7.01%. 

Loan B has a lower interest rate, but it's hiding a higher fee than Loan A. Samuel can see that the overall APR for Loan A is lower, so he takes that loan.

APY is the rate at which interest-based accounts grow each year. Most often seen with savings accounts, certificates of deposit (CDs), and money market accounts, the APY formula takes into account the principal balance and compounding interest to give you a realistic view of what your account will be worth in a year's time. 

To calculate your APY, all you need to know is your interest rate and how often it compounds. If it compounds yearly, good news — you already have your APY. 

Assume you're opening a high-yield savings account with an annual interest rate of 4% that compounds monthly. 

• First, divide your annual interest rate (as a decimal) by the number of times per year it compounds. 0.04 divided by 12 gives you approximately 0.00333. 
• Next, add one to the above number. 1 + 0.00333 is 1.00333. 
• Raise that number to the power of the number of times per year your interest compounds. So, raise 1.00333 to the power of 12 (or multiply 1.00333 by itself 11 times), giving you 1.0407.
• Subtract one from the previous result, leaving you with 0.0407. 
• Multiply the number to convert it to a percentage. 0.0407 x 100 is 4.07, meaning your APY is 4.07%.

Picture this. Hannah got a bonus of $3,000, and she wants to put it into a savings account to build. She has two options: 

Account 1 has a 5% annual interest rate that compounds monthly. It has an APY of 5.12%.

Account 2 has a 5.05% annual interest rate that compounds every 6 months. It has an APY of 5.11%.

If Hannah had looked only at the annual interest rate, she would've chosen Account 2. However, she can see that the APY of Account 1 is higher, so she chooses that one instead.

Although they're very similar, APR and APY have two main differences: the context and compounding.

• The context: Both concepts represent growth, but of different numbers. APR showcases how debt will grow over the course of a year, while APY tells you how much your savings or CDs will be worth in the same time frame. Because of this, banks tend to portray them very differently in advertising. A loan or a credit card with a low APR will attract much more attention than one with a high APR, but the opposite is true for a savings account and its APY — in that case, the higher, the better.
• Compounding: Because APR doesn't take into account compounding, it can be misleading. A credit card with a low APR can accumulate interest much faster than one with a high APR if the interest is compounding at a faster rate. On the other hand, APY accounts for compounding, giving you a clear and accurate idea of what the value of your account will be in a year.

The APR formula provides borrowers with a standardized way to compare offers from lenders without having to worry about daily or weekly interest rates. It also consolidates all the borrowing costs, ensuring borrowers don't choose a credit card with lower interest rates that are masking much higher fees. 

It's important to remember that, while APR should be a vital part of your decision, it shouldn't be the only factor. Remember to consider the compounding interest that APR doesn't account for, as well as fixed and variable rates.

APY is the most reliable number to use to compare savings accounts. Because it considers compound interest, it provides a more accurate look at what your savings account will be earning in a year than the interest rate alone does. A savings account with a higher interest rate might only be compounding once or twice a year, and one with a lower interest rate may compound once a month, resulting in more money for you at the end of the year.