APR vs APY: Which Number Really Matters?

APR and APY are two of the most commonly misunderstood terms in personal finance. Banks use these numbers to advertise their products, but most people don't realize they measure completely different things. Understanding this difference can save you thousands of dollars.

What Is APR?

APR stands for Annual Percentage Rate. It represents the yearly cost of borrowing money, including interest and certain fees, but WITHOUT considering the effects of compounding.

                        Key Point: APR is primarily used for LOANS and CREDIT CARDS - situations where you're borrowing money and paying interest.
                    

What APR Includes

Base interest rate
Loan origination fees
Discount points (for mortgages)
Other mandatory fees

What APR Doesn't Include

Compounding frequency effects
Optional fees (late payment fees)
Prepayment penalties

Example: A credit card advertises 18% APR. If you carry a $1,000 balance for one year:

Simple calculation: $1,000 × 0.18 = $180 interest
However, the ACTUAL interest you pay will be higher because credit cards compound daily!

What Is APY?

APY stands for Annual Percentage Yield. It represents how much you earn in one year, ACCOUNTING FOR compounding effects.

                        Key Point: APY is primarily used for SAVINGS ACCOUNTS, CDs, and INVESTMENTS - situations where you're earning interest on your money.
                    

The APY Formula

APY = (1 + r/n)^n - 1

Where:

r = nominal interest rate (as decimal)
n = number of compounding periods per year

Example: A savings account offers 5% interest rate compounded monthly.

The stated rate: 5%
The APY: (1 + 0.05/12)^12 - 1 = 5.116%

On $10,000, you'd earn $511.60, not just $500!

The Key Differences

1. Purpose

APR: Shows the cost of borrowing
APY: Shows the earnings from savings/investments

2. Compounding

APR: Doesn't account for compounding
APY: Includes compounding effects

3. Usage

APR: Loans, mortgages, credit cards
APY: Savings accounts, CDs, money market accounts

Real-World Scenarios

Scenario 1: Comparing Savings Accounts

Bank A: 4.5% interest, compounded annually
Bank B: 4.4% interest, compounded daily

Bank A APY: 4.5% (no compounding effect with annual)
Bank B APY: 4.49% (with daily compounding)

Watch Out! Bank B might advertise "4.49% APY" which looks better than Bank A's "4.5%" if you don't read carefully. Always compare APY to APY, not rates to APY!

Scenario 2: Credit Card Interest

Credit card: 18% APR, compounded daily

Many people think they'll pay 18% on their balance, but with daily compounding:
Effective rate (APY): 19.72%

On a $5,000 balance carried for one year:
Expected cost (18%): $900
Actual cost (19.72%): $986
Difference: $86 more than expected!

Scenario 3: Mortgage APR

Lender advertises: 6.5% interest rate

After including:

$2,000 origination fee
$500 application fee
$300 appraisal fee

Actual APR: 6.73%

This is why APR is more useful for comparing loan offers - it includes more costs.

When to Use Each One

Use APR When:

Comparing loan offers
Evaluating credit card costs
Shopping for mortgages
Assessing the true cost of borrowing

                        Pro Tip: Always ask for the APR, not just the interest rate, when shopping for loans. Federal law requires lenders to disclose APR.
                    

Use APY When:

Comparing savings accounts
Evaluating CD rates
Choosing investment accounts
Calculating actual earnings

                        Pro Tip: Banks must advertise savings accounts using APY, not just interest rates. This protects consumers by showing the true earnings.
                    

Common Mistakes to Avoid

Mistake 1: Comparing APR to APY

Never compare a loan's APR directly to a savings account's APY - they measure different things!

Mistake 2: Ignoring Compounding Frequency

Two accounts with the same rate but different compounding frequencies will have different APYs. Always check the compounding.

Mistake 3: Focusing Only on Rates

Don't forget to consider:

Minimum balance requirements
Monthly maintenance fees
Withdrawal penalties
Account access and features

Mistake 4: Not Reading the Fine Print

Promotional rates, introductory APRs, and tiered rates can make advertised numbers misleading.

Quick Reference Guide

Question	Answer
Comparing loan offers?	Use APR (lower is better)
Comparing savings accounts?	Use APY (higher is better)
Calculating actual earnings?	Use APY
Calculating actual loan costs?	Use APR (but check compounding)
Credit card interest?	APR is advertised, but actual cost is higher due to daily compounding

The Bottom Line

                        Remember:
                        APR = Cost of borrowing (loans)
APY = Earnings from saving (savings)
APY includes compounding, APR usually doesn't
Always compare apples to apples: APR to APR, APY to APY
Higher APY is better for savers; lower APR is better for borrowers

                    

Understanding APR and APY helps you make informed financial decisions. Whether you're choosing a savings account or comparing loan offers, knowing which number matters in each situation gives you the power to maximize your wealth and minimize your costs.

Use our interest rate calculator to see how APR and APY affect your specific financial situation.