Monday, March 19, 2007

APRs and APYs...What's the Difference?

If you've got a credit card, a savings account, or any kind of loan, there's no doubt you've been exposed to APYs and APRs. They're both methods of stating interest rates, but what's the difference? When and why is each used?

First, a few definitions:

APR - Annual Percentage Rate
APY - Annual Percentage Yield
Compounding - Earning interest on previous interest

The difference between the two is all about compounding. The APR is the annual rate of interest, without taking into account the compounding of interest within that particular year. The APY does take into account all that extra compounding within the year. It seems like a pretty small difference, but it can actually add up to some major bucks. This is really better shown with some formulas, illustrating their inter-relationship.

APR = Periodic Rate X Number of Periods in a Year

APY = (1 + Periodic Rate)^(# of Periods) - 1

"Holy crap, FNN! I haven't had algebra since high school. What the heck does that mean?"

Okay, a more real-world example: Say you've got a credit card that has an APR of 18%. That means that each month, you're charged 1.5% of the balance (1.5% X 12 months = 18%). Pretty simple, right? Well, look at it from an APY perspective: plug the numbers into the formula:

[(1+1.5%)^(12 months) - 1] = 19.56%

That's a difference of over 1.5%!

So what does this actually mean? Well, if you only carry a balance for one month's period, you'll be charged 1.5%, or the equivalent yearly rate of 18%. But, if you carry that balance for a year, your effective interest rate becomes 19.56%. That higher effective rate is all due to the effect of compounding each month.

"That's all well and good, but I'm still not getting it. How does this affect me in a broader sense?"

Well, it depends on your perspective.

As a borrower, you should always be searching for the lowest rate. The lenders know this, and will usually specify their rate in the lower of the two methods, the APR. This is because it doesn't account for compounding, and is a lower number than the APY.

The reverse is true if you're the lender, like when you're shopping for a savings account. The banks will usually specify the larger number, the APY because it accounts for the additional compounding.

So, when you're comparing rates of banks, credit cards, mortgages, savings accounts and everything else in the financial world, you've got to make sure that you're comparing the same thing, either APRs or APYs. It can make a big difference in your wallet.

YFNN

2 comments:

Anonymous said...

Is there a typo in this entry. You say that APY and APR are both Annual Percentage YIELD. I don't think that's what you meant.

YFNN said...

Ack! You're right! That's an important distinction, too!