Let’s face it: the world of credit and finance is full of acronyms, and it can be challenging to keep up with each and remember what they mean before another emerges! Two of the most common you’ll ever hear are APR and APY. For starters, let’s break down what both mean– APR stands for Annual Percentage Rate, and APY stands for Annual Percentage Yield. Despite sharing two-thirds of their names, both are very different and are used constantly when discussing money and credit.
In today’s Build blog, we’ll go over APR vs. APY, how each works, and how to keep each in mind regarding your money, credit, and future. By understanding more and more of these tricky acronyms, you can move forward in your finances more confidently and comfortably– starting with APR and APY is a great stepping stone. Let’s get into it below.
Understanding Compound Interest
To begin understanding APR vs. APY, it’s also vital to understand compound interest. Compound interest is when your interest makes interest– not confusing at all, right? Essentially, when you invest money in a savings account (or similar), the longer the sum stays in the account, the more interest it will earn. This is simply due to the amount of money in the account increasing due to the interest. When that interest increases your principal balance, you have more money to gain interest on. If you have $500 in a savings account that earns 5% interest yearly, you’d have $525 after one year; then, you’ll begin gaining 5% interest on that $525. After another year, you’ll gain $26.25, bringing your total to $551.25. The interest has “compounded” because the sum now includes the previous interest gained.
APR vs Interest Rate
Now that you understand how interest rates can compound with certain accounts and amounts, let’s discuss how an interest rate interacts with APR, your Annual Percentage Rate.
An interest rate related to your APR is more involved with loans or credit than a savings account’s interest rate. You can consider an interest rate as one aspect of an APR. If you have a loan or are using credit with an interest rate on the amount you pay back (each month, each year, etc.), that percentage is factored into your APR. Your APR is your loan or credit’s total fees and interest. From processing fees to late fees to closing costs, your APR factors everything into a percentage– including your interest rate– and presents the total cost of a loan or credit card usage. We’ll break down the details further in the next section below.
What is APR
As we began discussing above, an APR– Annual Percentage Rate– is the total cost to use a loan, credit card, or other sources of credit. While often confused with or used instead of “interest rate,” your APR is more involved. Your APR takes every type of fee and interest rate into account to determine the total percentage it takes to use a source of credit annually. Beyond the fixed interest rate, this includes late fees, processing fees, and other penalties. It presents them as one percentage to consider when using– or choosing– your credit card. Something to remember for credit cards is that your APR can be the same as your interest rate depending on the type of card you choose; moreover, it is also possible to get a credit card with 0% APR!
What is APY
Now that we’ve tackled APR, let’s look at your APY– the Annual Percentage Yield. To put it as straightforward as possible, let’s break down the meaning of how those three words work together: an APY is how much (Percentage) you stand to gain (Yield) after a year (Annually). With a savings account or certificate of deposit (CD), a set amount of interest is determined and used to grow the sum of money present year after year. In a regular savings account, you can deposit and withdraw money anytime, when, and where you need it. When you have an APY associated with your savings account, you obviously stand to make more money if there’s more money to work with. At the end of the year, your APY determines how much your money has grown. With a certificate of deposit, you determine a set amount of money to put into a bank and leave untouched for a set amount of time; you cannot deposit more money into a CD, and you cannot withdraw it (without facing penalties and fees). Because your money is inaccessible to you, the bank can use it while the CD is in place. Therefore, the APY associated with a certificate of deposit is usually higher, allowing your money to grow more than it would in a regular savings account.
APR vs. APY Example
Now that you understand what APR and APY are and how they differ, let’s compare them directly. An APR is the total cost of borrowing money or using credit. An APY determines how much money you have after any interest or compounded interest is included in your account. The APR is for borrowing, and the APY is for saving. However, if you’re using credit each year while building your savings with a certificate of deposit or savings account, keeping both percentages in mind will help you strategize using and building your finances responsibly.
What Affects Your APR?
So, what can change or affect your Annual Percentage Rate? Plenty of things. From a baseline perspective, creditors will increase interest rates and fees for people who seem more of a credit risk on paper. Your credit score, payment history, loan term, down payment, and type of credit all form your APR. The better and safer each of these feel to a lender or creditor, the lower APR you’ll be offered. When applying for a new source of credit or loan, be sure to go over your credit report, pay off any outstanding balances, and pay attention to what sort of credit card or loan you’re applying for.
The bottom line is that APR and APY are both important in credit and finance. Understanding how each term works with your money will help you plan for a better future– whether that’s in applying for new credit sources, saving money, or both! Fundamentally, remember that your APR is for borrowing, and your APY is for saving. Always discuss and compare APRs and APYs with your credit card company and bank, respectively. With the proper research and preparation, you can get an APR and an APY that both work for you at optimal rates. Best of luck!
Disclaimer: Difference Between APR vs. APY is intended for educational/informational purposes only and is not intended as financial advice.