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Understanding How APR, APY and Interest Rates Work and Impact Your Finances

·3 min read
MicroStockHub / iStock.com
MicroStockHub / iStock.com

You know APR and APY as the three-letter acronyms hiding in tiny font at the bottom of a credit card application or investment prospectus. But no matter how small the print, it’s unlikely that you’ll find six letters anywhere in the world that will have a bigger impact on your financial life. Here’s what you need to know.

The Economy and Your Money: All You Need To Know
See: How Interest Rates Affect Your Wallet and the Bigger Economic Picture

APR vs. APY: You Can Tell a Lot by Where You See Them

APR stands for “annual percentage rate.” APY stands for “annual percentage yield.” They’re closely related — both deal with interest paid or collected — but they’re not the same.

  • Generally, people who want to give you money (lenders) tell you about the APR

  • People who want to take your money (investment firms) will quote the APY

There’s a good reason for that. APR is always lower and APY is always higher. Credit card companies and other lenders want the interest you’ll pay to appear lower, so they quote the APR. People selling investments like CDs and bonds want your returns to appear greater, so they quote the APY.

More Economy Explained: What Is Inflation and What Does It Mean When It Goes Up or Down?

APR Is Less, APY Is More and in Between Is Compound Interest

Albert Einstein is quoted as saying: “Compound interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t … pays it.”

If you weren’t sure whether or not Einstein was a pretty smart guy, ask yourself the following question. If someone offered you the choice between a million bucks today or a penny that doubles every day for one month 30 days from now, would you take the stack of cash or the coin?

Find Out: Understanding the Differences Between Inflation, Deflation & Stagflation

Most people would probably take the $1 million — and one month later, they’d be sorry. Thanks to the power of compound interest, that single penny would be worth over $5 million in 30 days.

Simply put, APR reflects only the periodic interest rate multiplied by the number of periods in one year. If a credit card charges 1% monthly interest, for example, the APR is 12% because there are 12 months in a year. That calculation does not reflect how frequently the interest is applied or the effect that compounding has on it throughout the year.

APY does.

Helpful: How To Calculate Your Debt-to-Income Ratio

The calculation to determine APY — which reflects intra-year compounding — is a bit more complicated:

  • Add 1 plus the periodic rate in decimal form and multiply it by the number of periods that the rate is applied, then subtract 1, or:

  • APY = (1 + periodic rate)number of periods – 1

Do that, and you’ll notice that — thanks to the power of monthly compounding — the credit card from the previous example with an APR of 12% has an APY of 12.68%. If you think that 0.68% doesn’t sound like too much extra, carry a balance for a few months and see what happens.

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See: What Does the Fed Do, Anyway?

Be Mindful of the Difference and Ask for Clarification

Investment firms state the APY because they know that all investors want to maximize the effect of compound interest on their investments. Lenders quote the APR because they know that all borrowers want to minimize the effect of compound interest on their loans. They’re always going to show the more attractive number. If you’re not sure which rate they’re quoting, ask for clarification.

Keep in mind that APY is also called EAR, or “effective annual rate.” That’s because the effective annual rate that you’ll pay for a loan or earn on an investment depends wholly on how frequently the interest compounds throughout the year. Before you sign on the dotted line, ask to see both numbers — and always remember how quickly a penny can grow into a fortune. Do Einstein and yourself a favor and be the one who collects the fortune, not the one who pays it.

This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.

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Last updated: Sept. 1, 2021

This article originally appeared on GOBankingRates.com: Understanding How APR, APY and Interest Rates Work and Impact Your Finances