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A Deeper Look: APR vs. APY

By Jeff Brown
You see it all the time, an “APR” or “APY” that differs from the interest rate on a loan or interest-paying account.

Category Product: 
CDs
Category Finance: 
Personal Finance
Symbols: 
C
BAC
Keywords: 
APY, APR, CD, Certificate of Deposit, Annual Percentage Rate, Mortgages, Interest, Loan, Bank of America, Citibank
Introduction: 

By Jeff Brown
You see it all the time, an “APR” or “APY” that differs from the interest rate on a loan or interest-paying account.

APR is annual percentage rate, an interest rate you would pay on a mortgage or other loan. APY is annual percentage yield, an interest rate you would receive on a certificate of deposit or other interest-earning investment.

Often, the difference between these and the stated interest rate looks too small to worry about, but in fact, it does.  In shopping for a loan or investment, you’re generally better off focusing on the best APR or APY rather than the raw interest rate.

These annual percentage figures show what you will really pay or earn over 12 months in real-world conditions, counting the effects of compounding, or earning interest on interest and the damage from fees that aren’t included in the interest rate.

For example, manybanking.com’s Certificate of Deposit Calculator shows how an interest rate earned on a certificate of deposit converts into an annual percentage yield.

To make it simple, assume you buy a $1,000 CD with a 10 percent interest rate for 12 months. If you have the interest compounded once annually, you’d earn $100 in interest over 12 months, just as you would expect. The interest rate and APY are both 10 percent.

However, through daily compounding, you earn $105 and the APY nudges up to 10.516 percent, even though the interest rate is still 10 percent. The reason is that when you compound daily, the interest payments are credited to your account every day, so each day you earn interest on the interest you received in previous days.  Because compounding annually means the interest is credited once, at the end of the year, so there is no chance to earn interest on interest.

The APY is especially useful if you are comparing two or more CDs that differ in a variety of ways, not just interest rate. One may compound daily, another monthly or quarterly. Or one may have a six-month term, another 12 or 18 months. The APY figures adjust for all these variables, so you can tell which CD is the most generous by looking at just that one figure.

In fact, manybanking.com’s tool for comparing CDs uses APY rather than interest rate. Bank of America (Stock Quote: BAC) offers a 12-month CD with a 2.5 percent APY, while Citibank (Stock Quote: C) has one at 2.6 percent. You don’t have to look much deeper to know the Citibank deal is better.

Next, look at the Mortgage APR Calculator. The default figures show a $100,000 loan for 30 years at an interest rate of 6.25 percent. The annual percentage rate is higher -- 6.514 percent, because it includes the $2,800 in closing costs. Change the three closing cost windows to zero and the APR is the same as the interest rate, 6.25 percent.

As with the certificate of deposit, the annual percentage figure makes it easier to compare two mortgages with a variety of different features, such as the loan term, origination fees, points and other closing costs. In some cases, a loan with a higher interest rate but lower closing costs can actually be cheaper.

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APR is annual percentage rate, an interest rate you would pay on a mortgage or other loan. APY is annual percentage yield, an interest rate you would receive on a certificate of deposit or other interest-earning investment.

Often, the difference between these and the stated interest rate looks too small to worry about, but in fact, it does.  In shopping for a loan or investment, you’re generally better off focusing on the best APR or APY rather than the raw interest rate.

These annual percentage figures show what you will really pay or earn over 12 months in real-world conditions, counting the effects of compounding, or earning interest on interest and the damage from fees that aren’t included in the interest rate.

For example, manybanking.com’s Certificate of Deposit Calculator shows how an interest rate earned on a certificate of deposit converts into an annual percentage yield.

To make it simple, assume you buy a $1,000 CD with a 10 percent interest rate for 12 months. If you have the interest compounded once annually, you’d earn $100 in interest over 12 months, just as you would expect. The interest rate and APY are both 10 percent.

However, through daily compounding, you earn $105 and the APY nudges up to 10.516 percent, even though the interest rate is still 10 percent. The reason is that when you compound daily, the interest payments are credited to your account every day, so each day you earn interest on the interest you received in previous days.  Because compounding annually means the interest is credited once, at the end of the year, so there is no chance to earn interest on interest.

The APY is especially useful if you are comparing two or more CDs that differ in a variety of ways, not just interest rate. One may compound daily, another monthly or quarterly. Or one may have a six-month term, another 12 or 18 months. The APY figures adjust for all these variables, so you can tell which CD is the most generous by looking at just that one figure.

In fact, manybanking.com’s tool for comparing CDs uses APY rather than interest rate. Bank of America (Stock Quote: BAC) offers a 12-month CD with a 2.5 percent APY, while Citibank (Stock Quote: C) has one at 2.6 percent. You don’t have to look much deeper to know the Citibank deal is better.

Next, look at the Mortgage APR Calculator. The default figures show a $100,000 loan for 30 years at an interest rate of 6.25 percent. The annual percentage rate is higher -- 6.514 percent, because it includes the $2,800 in closing costs. Change the three closing cost windows to zero and the APR is the same as the interest rate, 6.25 percent.

As with the certificate of deposit, the annual percentage figure makes it easier to compare two mortgages with a variety of different features, such as the loan term, origination fees, points and other closing costs. In some cases, a loan with a higher interest rate but lower closing costs can actually be cheaper.

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