Convert APR, APY, and uncover the effects of compounding.
When borrowing money or opening a savings account, you will frequently encounter two acronyms: APR (Annual Percentage Rate) and APY (Annual Percentage Yield). Understanding the difference is critical to making smart financial decisions.
In short, APR represents the "simple interest" cost of borrowing money over a year, while APY includes the effects of compounding interest (when interest is earned on previously earned interest).
Banks and financial institutions use these terms strategically based on whether you are borrowing money from them or lending money to them (via a savings account).
When Borrowing (Credit Cards, Loans): Lenders advertise the APR because it is a lower number than the APY, making the loan look cheaper.
When Saving (Savings Accounts, CDs): Banks advertise the APY because it is a higher number, making the returns look more attractive.
Compounding frequency dictates how often interest is added to your principal balance. The more frequently interest compounds (e.g., daily vs. annually), the greater the difference between the APR and the APY.
For instance, an investment with a 10% APR compounded annually has an APY of exactly 10%. However, that same 10% APR compounded daily results in an APY of approximately 10.52%. Over decades, this difference creates exponential growth.