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APR V.S. APY, How They Work And How They Affect Your Personal Finances

Updated on December 22, 2015

Interest rates are one of, if not the most important factor to consider when making the decision to borrow or invest money. Interest rates on financial products like a credit card or investment funds can appear in two ways. The first is the Annual Percentage Rate (APR) also known as the nominal interest rate. While the second is the Annual Percentage Yield (APY). Finding it difficult to differentiate between the two?

The Difference?

Try Think of it this way: the APR is what is offered, while the APY is what you actually get.The APY takes compounding interest into consideration while the APR does not. The more frequent the interest is compounded, the bigger the variance will be between the APY and APR. For obvious reasons, debt-based financial products like as credit cards usually list the APR for because the APR assumes a compounding rate of Once per year which makes it lower of the two. However, the APY will more often appear on financial products that yield interest income like a CD, as it is generally higher than the APR percentage.

How it all Work

Here is an example of APR and APY in action to further illustrate their differences: If a credit card charges a base interest rate of 1.5% per month, it ultimately would list an APR of 18% (1.5% per month x 12 months). However, the same account would reflect an APY of 19.56%. Now, why is there a difference? Imagine you make a purchase on your credit card for $1000. Providing now payment is made or late fee applied, the progression of the $1000 would go as follows.

 
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Principle: $1000
$1,015
$1,030
$1,046
$1,061
$1,077
$1,093
$1,110
$1,126
$1,143
$1,161
$1,178
$1,196
Interest Charges
$15
$15
$15
$16
$16
$16
$16
$17
$17
$17
$17
$18

In the example above, the compounding rate is once per month, had it been more frequent like once per week or once per day, the APY would have an even bigger variance from the APR. The same is true for calculating the interest costs on a loan.

.

How They Affect Your Personal Finance

Based on the APR on the face of the Credit card, you would expect to be charged $180 of interest for the (12 month period). But in this example listed above, because the interest was compounded monthly, the actual interest charged would be $196 by the end of the 12 month period.

The next time you glimpse across the either the APR or APY on a credit card statement or a CD agreement, I hope it would look a little more familiar and a lot less intimidating. If you find this useful, check out these Personal Finance Tips.

Browsing? no time to read? Check out this quick Video explaining the difference between APR and APY

© 2015 Keino Chichester

Comments

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    • Keino C profile imageAUTHOR

      Keino Chichester 

      2 years ago from Brooklyn, NY

      Thank you!

    • profile image

      Howard Schneider 

      2 years ago from Parsippany, New Jersey

      Great information, Keino. Credit card companies are always finding new ways to screw their customers. Excellent Hub.

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