# What Is APR and How It Differs from APY

Albert Einstein reportedly referred to compound interest as the greatest force on earth. Whether you agree or not, you should understand the common financial tools that use compound interest, such as annual percentage rate (APR) and annual percentage yield (APY)and, more specifically, the difference between them. Both are used to calculate interest for investment and credit products. But what are they? Keep reading to find out more about the difference between these two interest calculations and what they mean for both borrowers and lenders.

### Key Takeaways

• An annual percentage rate represents the annual rate charged for earning or borrowing money.
• An annual percentage yield takes into account compounding, but an APR does not.
• Earned annual interest is another definition of how an annual percentage yield is earned.
• Credit card companies are required to disclose the APR on the card to customers.

## What Are APR and APY?

It’s easy to understand why people may confuse the terms annual percentage rate and annual percentage yield. Both are applied to investment products and loans and, while they may sound the same, they are, in fact, quite different and are not created equal. In fact, they significantly affect how much you earn or must pay when they’re applied to your account balances.

Investment companies generally advertise the APY they pay to attract investors because it seems like they’ll earn more on things like certificates of deposit (CDs), individual retirement accounts (IRAs), and savings accounts. But it’s a little different when it comes to lenders. Financial institutions often tout their credit products using APR since it seems like borrowers end up paying less in the long run for accounts like loans, mortgages, and credit cards.

APR does not take into account the compounding of interest within a specific year. It is calculated by multiplying the periodic interest rate by the number of periods in a year in which the periodic rate is applied. It does not indicate how many times the rate is applied to the balance.

APR is calculated as follows:

﻿APR=Periodic Rate × Number of Periods in a YearAPR=text{Periodic Rate }timestext{ Number of Periods in a Year}﻿

APY, on the other hand, does take into account the frequency with which the interest is applied—the effects of intra-year compounding. This seemingly subtle difference can have important implications for investors and borrowers. APY is calculated by adding 1+ the periodic rate as a decimal and multiplying it by the number of times equal to the number of periods that the rate is applied, then subtracting 1.

Here’s how APY is calculated:

﻿APY=(1+Periodic Rate)  Number of Periods−1APY=(1+text{Periodic Rate) }^{text{ Number of Periods}-1}

### APR and APY Example

A credit card company might charge 1% interest each month. Therefore, the APR equals 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest.

The APY for a 1% rate of interest compounded monthly would be 12.68% [(1 + 0.01)^12 – 1 = 12.68%] a year. If you only carry a balance on your credit card for one month’s period, you will be charged the equivalent yearly rate of 12%. However, if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of compounding each month.

## What Is Compounding?

At its most basic level, compounding refers to earning or paying interest on previous interest, which is added to the principal sum of a deposit or loan. Most loans and investments use a compound interest rate to calculate interest. All investors want to maximize compounding on their investments, and at the same time minimize it on their loans. Compound interest differs from simple interest in that the latter is the result of multiplying the daily interest rate by the number of days between payments.

Compounding is especially important in our APR versus APY discussion because many financial institutions have a sneaky way of quoting interest rates that use compounding principles to their advantage. Being financially literate in this area can help you spot which interest rate you really get.

## The Borrower’s Perspective

As a borrower, you are always searching for the lowest possible rate. When looking at the difference between APR and APY, you need to be worried about how a loan might be disguised as having a lower rate. Another term for APY is earned annual interest (EAR), which factors in compounding interest.

For instance, when you’re shopping around for a mortgage, you are likely to choose a lender that offers the lowest rate. Although the quoted rates appear low, you could end up paying more for a loan than you originally anticipated.

### Different countries have different rules and regulations in place to combat some of the unscrupulous activity surrounding quoting rates that have arisen in the past.

This is because banks often quote you the annual percentage rate on the loan. But, as we’ve already said, this figure does not take into account any intra-year compounding of the loan either semi-annually, quarterly, or monthly. The APR is simply the periodic rate of interest multiplied by the number of periods in the year. This may be a little confusing at first, so let’s look at an example to solidify the concept.

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