APR (Annual Percentage Rate) and APY (Annual Percentage Yield) are both related to the effective interest rate in financial transactions.
The interest rate is the cost of borrowing money but often financial transactions are complex and the interest rate does not paint the full picture. An APY or APR is a better way to compare transactions and this article will explain how.
What is APR?
APR stands for Annual Percentage Rate. It is the effective interest rate paid by a borrower, which is often different from the nominal interest rate. For large loans like a mortgage, the lender charges sundry fees to the borrower that are in addition to the interest rate. When the financial impact of all such fees is considered, the effective cost of borrowing is much higher than the interest rate on the loan. This effective cost of borrowing — or the interest rate — is called Annual Percentage Rate.
Why use APR?
The APR offers a better way to do an apples-to-apples comparison between loan offers from different lenders. For example, Lender A may offer a 3% interest rate but charge a 1% origination fee for a mortgage, while Lender B may offer a 3.1% interest rate but charge no origination fee. In such a scenario, the APR for Lender A will be higher than Lender B, so the consumer would be wise to choose Lender B even though the interest rate there is higher.
What is APY?
APY is used when the consumer lends money to a bank i.e., makes a deposit such as a CD or savings account. The deposit accrues interest at the interest rate offered by the bank. However, the compounding frequency may be different or there may be other gotchas that eat into the effective yield of the investment. So the interest rate may not be the best metric to use to compare different investment options. Enter the Annual Percentage Yield, or APY. The APY is the effective yield of the investment on an annualized basis, assuming that all interest/dividends earned are re-invested. When comparing savings or money market accounts from two financial institutions, use the APY offered to choose where to invest.
APR vs. APY: Video explaining the difference