Understanding the difference between the Annual Percentage Rate (APR) and Annual Percentage Yield (APY) helps in making smart financial decisions.
A basic concept that has to be kept in mind while understanding these two terms is Compound Interest, or interest that is earned on previous interest amount. The simple rule of the thumb to be followed while making investment decisions is that one must try to maximize this compound interest component while making an investment or saving, and reduce this compound interest component to a minimum while borrowing.
APR as the name implies is simply the rate or the annual rate that is charged by the bank on the loan amount borrowed by a person. It doesn’t take into consideration the subsequent interest component. Thus APR is often arrived at by multiplying the Periodic rate by the number of periods that come in that year. One point to remember is that ARP is used in conjunction with the loans borrowed from the banks.
This periodic rate is applicable on the balance loan amount outstanding for a borrower. To simplify this term with an example, let’s assume a borrower has taken a loan on a nine percent interest rate. Then the periodic interest rate payable at the end of the year is 9% or 0.75% monthly rate of interest is payable on the loan balance amount. Compound rate of interest is not applicable to APR.
APY or Annual Percentage Yield could be applicable in a lending as well as a saving scenario. APY deals with how the interest rate is applied. In case it is being used to determine how much saving would result for a particular investor, APY would give the interest that would be earned by the investor at a particular rate of interest. APY takes into consideration the compound rate of interest, applicable within the year itself.
For example, a lending company might charge 1% interest each month; which means that, the APR would be 12% (1% x 12 months = 12%). This is entirely different from APY, which would be inclusive of the compound interest component. The APY for a 1% rate of interest compounded monthly would be 12.68% a year. Calculation: (1 + 0.01)^12 – 1= 12.68%
This means that the lending company would charge an entire year’s interest on the amount outstanding to a borrower who carries the outstanding balance over one month period. In the event that the amount is carried over for an entire year, due to compounding rate of interest the effective interest rate becomes 12.68%. Which effectively means that each month’s interest component gets added cumulatively.
As a borrower what one needs to check is the intra-year compounding, either monthly, quarterly, semi- annually or annually, that is applied by the bank while calculating the interest. What is usually quoted by the banks is the APR, whereas the APY actually gives an insight to any compounding that may be applicable.
From a lenders perspective, the situation is clearly reversed. Here the banks or the financial institutions may try to entice investors by quoting the obviously higher APY, instead of the APR. However it is important to evaluate the returns by considering the two as the amount earned may be significantly impacted.
There are certain rules imposed by the government to ensure that there are no variations and hence subsequent misuse as applicable to interest rates, however arming oneself with the knowledge about these two terms ARP and APY would ensure that one doesn’t fall prey to such scams or fraudulent schemes.
Thus the important point to be kept in mind is that it is imperative to compare apples to apples or APY to APY and ARP to ARP while making financial decisions.