May 22, 2014
APR and APY – are they new texting acronyms? IDK, you say – or rather, you text? (For the benefit of the textually-challenged, IDK means “I don’t know.”) If you think they are texting acronyms, or just “DK” what they are, it’s time to learn.
APR and APY are financial acronyms, short for Annual Percentage Rate and Annual Percentage Yield, respectively. Both are interest rates, but they have a significant difference. APR does not address how interest is compounded – the default is the interest that you earn if you are depositing money, or pay if you are borrowing it – in one year. APY takes into account how often the interest is compounded.
If interest is compounded once per year, there is no difference between APR and APY – interest is added all at one time. However, let’s assume an interest rate is compounded monthly. In that case, the interest payment is divided up into twelve equal increments.
If you are earning interest on a deposit, that adds a small amount of extra money in interest with each period, and the first payment has eleven more periods that year to gain interest. The one from the second month has ten more periods to gain interest, and so on. Taking that extra interest into account increased the return, or yield, on your investment in that year as you earn interest on the interest you have already been credited.
APY is a way of averaging that extra interest throughout the year and adding that amount to the APR as a fraction of an interest rate. This makes APY useful for comparing loans, terms or investments with different compounding periods.
For a three percent APR, the conversion works out to a 3.04 percent APY. That does not seem like much of a difference, but consider the typically high interest rates of a credit card.
Assuming monthly compounding, a 24 percent APR interest rate becomes an effective 26.82 percent APY, and at 30 percent APR the effective APY is 34.49 percent. This is what you will really be paying if you carry a balance. If you never carry a balance, neither one of those rates matter because you are never charged interest.
Most loans or credit cards – in general, anyone lending money – will highlight the APR and downplay the APY because it appears more favorable. Conversely, banks, investments and anybody paying interest will usually quote the APY instead of the APR to make interest rates appear more favorable.
Generally, you find one highlighted and the other buried in the fine print. If not, there are plenty of online calculators to help you swiftly convert.
When comparing APRs to each other, you still have to look through the fine print. For example, credit cards often charge different APRs for different types of transactions (because their costs are not the same). Cash advances often have a higher APR than regular credit purchases.
You may also have a promotional APR with a low rate for a short period of time, or even a zero percent APR – anytime a zero percent APR is quoted you can rest assured that there are fees and other expenses that allows the creditor to make money.
Mortgages are even trickier, because the APR definition goes beyond the annualized rate and incudes “all costs” associated with borrowing money – including fees and certain closing costs.
In theory, this should allow a direct comparison of loan costs. In practice, different lenders may consider some costs and fees in the APR calculation while others consider them to be separate fees. There are general guidelines in what to include in the mortgage APR, but no standard.
So R U K w/APR vs. APY? HTH. TTFN. If you are over 30, text your kids to ask them what this means!
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