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APR vs. APY: What's the difference?

The financial industry is full of acronyms, and none of them are very easy to remember. As the world throws all kinds of FDIC, ATM, CD, IRA, and NSF stuff at you, you may be asking, WTH?

You have better things to do than repeatedly Googling, “What does ACH mean?” So, we’re here to clear up two of the most common conflated terms for you.

Here’s the definitive guide to APR vs APY, including explanations of both terms and a comparison that’ll help you understand how these acronyms are used and what they could mean for your financial future.

What is APR?

Annual percentage rate (APR) is the yearly interest rate borrowers pay as part of their loan agreement. While APR reflects the cost of borrowing funds over a full year, including fees, it does not account for compounding interest. Therefore, APR is only accurate for loans based on simple interest, not compounded interest.

You’ll most commonly see APR attached to:

  • Credit cards

  • Car loans

  • Personal loans

  • Home loans/mortgages

  • Home equity loans

  • Student loans

  • Personal lines of credit

Thanks to the Truth in Lending Act (TILA) of 1968, all financial institutions are legally bound to disclose the APR attached to a loan or other financial offering prior to completing an agreement of contract with a consumer. That means you have to be shown the APR up front—they are unable to trick you with an initial rate and add a different one once you’ve already signed on the bottom line.

How APR works

The terms “APR” and “interest rate” are often used interchangeably because APR is expressed as an interest rate. You’re being told how much interest you’ll be paying for the whole year rather than estimating a monthly rate or fee. It’s a way to see the big picture and make more informed decisions by understanding the true cost of a potential loan.

It may help to see what goes into calculating APR:

  1. Calculate: Fees + Interest / Principal

  2. Divide the number found in step one by n, also known as the number of days in a loan term

  3. Multiply your new number by 365 (the number of days in a year)

  4. Multiply that number by 100 to reach your percentage

Alternatively, think of it like this:

  • APR = (((Fees + Interest) / Principal / n) x 365) x 100

So, for a $100,000 loan with a 10-year term, $2,500 in interest, and $950 in fees, the APR calculation would look something like this:

  • ((($950 + $2,500) / $100,000 / 3,650) x 365) x 100 = 34.50% APR

Pro tip: That is NOT a good rate.

Using APR to compare loans

APR is useful for gauging the overall cost of borrowing, especially as it varies from lender to lender. If you’re torn between taking out a loan from Lender A versus Lender B, you might use APR to see which lender has terms that are more favorable.

Remember, though, that APR calculation methods may differ from lender to lender. That’s because there’s not a universally agreed-upon methodology. Some lenders include fees, while others don’t, so by all means compare APR, but make sure you read the fine print, too. Thankfully, that good ole TILA also states lenders have to disclose:

  • Additional fee/charges beyond the APR of your loan

  • Your scheduled payments, shared in a complete list of what you’re expected to pay in principal and interest over time. This is also referred to as an amortization schedule for mortgages.

  • The total cost of your loan, including how much you’ll ultimately pay once you complete the full loan term

In other words, the info is all there, you just need to put on your nerd hat (#nerdsarethecoolest) and read every single letter.

What’s a good APR?

Ask five people what constitutes a good APR and you’ll probably get five different answers, but there’s one thing you can count on: the lower APR a loan has, the less you’ll probably end up paying in interest.

When you apply for a loan, the APR you’re offered will depend on factors like your credit score, the type of loan you’re seeking, and the health of the market. Some lenders have a single APR given to all potential customers. Others work with APR ranges attached to credit scores or use calculators to give rates specific to each qualified applicant.

The best APR you can get is 0.00%, but that rate is almost always temporary. Otherwise, lenders would go out of business. If you’re offered 0.00% APR, read the fine print to see when that super-appealing introductory rate expires and what your APR will go up to after that period runs out.

Also keep in mind that APR is often presented as a package deal. A credit card with a good APR may have fewer perks available, meaning you pay less in interest, but you aren’t going to get travel points or cash back. Cards with high APR and tons of perks—partner discounts, dining points, etc.—can be very tempting, but the fees you’ll pay when carrying a balance could negate those benefits in a heartbeat.

What is APY?

Whereas APR focuses on what you’ll pay on a loan, annual percentage yield (APY) centers on what you get back from an interest-paying account. This calculation reflects the total interest earned from a bank account, a savings account, or another entity like a certificate of deposit (CD).

APY can be difficult for people to wrap their heads around because it’s a form of compound interest. As the interest generated is added to the account principal, the amount of interest generated grows. It’s like figuring out the interest you’re making on your interest.

Oh, and on the topic of APY vs. interest rate, remember that APY isn’t actually an interest rate—it’s a rate of return.

How to calculate APY

The basic formula for calculating APY is:

  • APY = [1 + (r / n)] ^ n – 1

In this case, r stands for “interest rate” and n stands for “number of compounding periods in a year.” If the interest compounds monthly, n = 12 (for 12 months in a year). If it compounds quarterly, n = 4 (four quarters in a year).

At this point, feel free to take a break. Grab a coffee, go for a swim, or watch reality TV. Your brain deserves the break. But come back, because this is important stuff, and it’s just getting good.

Okay, ready to go again? Let’s dive back in with an example of APY based on an initial deposit amount of $1,000, a 3% interest rate, and monthly compounding.

  • [1 + (3/12)] ^ 12 -1 = 3.042%

Assuming you never added any additional money to the account and relied solely on the initial deposit and compounding interest, after 1 year your account would hold $1,030,42. After 2 years, you’d have $1,061.76 — again, because you’re earning interest on your interest.

What’s a good APY?

Just like APR, there’s no single standard that points to a good APY. It’s all relative. But also like APR, a low APY means less money generated (in this case, less cash headed to your pocket), while a high APY means more money changing hands.

APY vs. APR: What’s the difference?

It’s easy to conflate APY and APR. The two acronyms have two-thirds of their letters in common, and they’re both frequently used to describe annualized rates related to financial accounts. But there are more differences than there are similarities.

  • APR

    relates to what a consumer

    owes a lender

    . The financial institution is telling you (as they have to, by law) what you’ll be paying in exchange for being loaned money. There’s no compounding interest in play, it’s just the stated annual interest rate in a fairly straightforward form.

  • APY

    relates to what a consumer

    stands to earn

    . It also looks at rate of return on a compounding basis, meaning it’s measuring interest on interest, not simply interest on the initial principal.

Even though one is about owing and one is about earning, they’re both essentially the same calculation other than the compounding component. But that component is hugely important when you’re trying to figure out how quickly the money in your savings account might grow. You want that compounding factor included so you have a more realistic picture of what your savings might look like in a year or 2 years or even 10 years.

Why you need to read the fine print

We get it, the fine print is boring. When researchers gave study participants a wacky contract demanding each individual hand over naming rights to their first child and invite a personal FBI agent to Christmas dinner for the next 10 years, 99% of survey respondents signed off. That’s because only 1% of those surveyed actually read the contract’s Terms and Conditions.

You don’t want to make the same mistake while figuring out your finances.

Always, always read the fine print before you take out a loan, sign up for a bank account, or apply for a credit card. In some cases, you may be on the hook for fees the minute you ask for money. In other cases, you could find yourself the subject of a bait-and-switch scheme, where you’re promised one thing only to find out your loan is something else entirely.

The last thing you want is to be locked into a contract that has unfavorable terms.

Here are a few things to look for, and if you don’t find the answers in the fine print, ask your loan officer or other banking rep and get their answers in writing.

  • Is the APR/APY fixed rate or variable?

    This will tell you whether you can expect to have the same rate for the life of the loan or if your rate could change based on contract terms, market rates, your credit score, or other factors. You can’t compare a fixed-rate loan to a loan with variable-rate interest—it’s like apples and oranges.

  • How often will interest compound?

    Compounding frequency varies from daily to annually compounding, with all kinds of weekly, monthly, and quarterly rates in between. The shorter the compounding period is, the higher your yield will be, so if you have a choice, go for the most frequent option on the table. For instance, a bank-quoted APR of 5.00% is actually 5.09% if compounded quarterly and 5.11% if compounded monthly. A small but still impactful difference.

  • What fees/costs are not included in APR/APY?

    Know up front whether there are fees not included in the initial numbers provided by your lender. For instance, you may have to pay insurance separately with one lender while the other rolls it into your loan amount, and each option will result in a far different monthly number.

Learning about terms like APY and APR can be the first big step toward financial literacy, and the more literate you are, the more in control you’ll be of your hard-earned cash. Worried about poor credit scores affecting your rates? The Varo Believe Credit Card helps you build credit with no minimum security deposit, no annual fee or interest, and no hard credit check to apply.¹ Open a Varo Bank Account today to get started.

1To be eligible to apply for the Varo Believe Card, you need to have received Incoming Deposits of $200 or more in the past 31 days to your Varo Bank Account and/or Savings Account. Incoming Deposits include any deposit into your Varo Bank Account and/or Savings Account from any source outside of Varo, Varo to Anyone transfers between Varo customers, and final dispute credits. After three months of timely payments on the Believe card and no late payments on other credit, Varo Customers who had an existing VantageScore® 3.0 credit, on average, saw an increase in that score of approximately 42 points. Individual results may vary, and some customers may not see a score increase.

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