Differences Between APR, APY And Interest Rates

Interest, essentially, is the cost that the borrower must pay to the lender.

When someone borrows money, the original loan (the principal) must be paid back in full eventually. However, in order to incentivize the lender to lend in the first place, the money’s growth potential must be repaid, too. The borrower will pay a fee to the lender, typically a percentage of the outstanding balance. This is known as interest.

Furthermore, interest can serve to compensate the lender for taking on risk, since that loan might not be paid back on time or in full. Generally, the higher the perceived risk of not seeing the money again (defaulting) to the lender, the higher the interest charged.

Interest does not always flow one way. For instance, in the case of a savings account, for example, an account holder is technically lending money to their bank, and the bank pays the account holder interest for the privilege of holding their money.

An interest rate is usually expressed as a percentage of the principal. This rate may be fixed or variable (subject to fluctuation). Typically, the borrower will seek out as low an interest rate as possible. Lenders aim to offer competitive rates that still allow them to turn a profit.

Interest rates can vary widely even within the same category of loan, depending on the circumstances. Different types of loans come with different types of payments, all with their own terminology to remember.

APR

An annual percentage rate (APR) represents the yearly interest charged when you borrow.

Although loans are usually paid more frequently (like your monthly credit card payment) the APR represents a loan’s periodic rate (the interest rate given for a specific time period, such as a day or a month) multiplied by the number of periods in a year. This makes it a useful point of comparison, as the annualization provides a common reference for all sorts of loans with different periods and terms.

One important distinction about APR is that it does not take into account compound interest—interest that is calculated off of the principal plus accumulated interest from previous periods, rather than just the principal. Because of its usefulness for comparison, APR is still often employed to describe loans with compound interest—such as credit cards—even though it will undershoot the actual cost to the borrower. This is why it’s sometimes called a “nominal APR.”

APY

The annual percentage yield (APY) represents the amount of interest you’ll earn annually when you save. It can also be known as earned annual interest (EAR).

It’s mostly used by banks and investors to represent the rate of return you’ll get on a high interest savings account or other type of investment.

Unlike APRs, APYs account for compound interest, and as such they express an investment’s true yield to the lender. They also don’t account for any ancillary fees. APYs often describe a rate with a higher figure than a nominal rate; the higher the frequency of compounding, the greater the difference between the two.

This is part of why APYs and APRs have come to find such different uses even though they represent similar concepts. When lending, a financial institution will advertise APR, because without the added value of compound interest, the interest rate appears lower and more desirable to the borrower. When that same institution wants to attract investors, it advertises APY, which will look like a higher number, representing a more attractive interest rate to a potential lender.

It doesn’t matter whether you are taking out a mortgage, applying for a credit card or setting up a savings account—it’s important to understand interest rates and the common representations. APRs and APYs both offer vital insight into the loans and investments they describe, though it’s necessary to be wary of the limitations of each at the same time. While APYs are often a more realistic indicator of interest owed, APRs can be more illuminating of the other costs associated with borrowing besides an interest rate. With an understanding of these differences, a consumer can consider his or herself armed with the ability to draw effective conclusions from these common ways of describing interest.