4 Common Budgeting Mistakes
- No specific motivation
- Unrealistic spending estimates
- Overlooked expenses
- Too many restrictions
It’s easy to get confused when the concepts of annual percentage yield (APY) and annual percentage rate (APR) are being tossed around. You’ve probably come across these acronyms when opening new financial accounts or reviewing the terms on your existing accounts, but what exactly do they mean? What is the difference between APY and APR?
In their simplest forms, APY refers to what you earn on the cash that’s stashed in a savings vehicle, while APR refers to what you owe when you borrow. While it may sound like something that belongs in an advanced finance class, understanding the difference between APY and APR can help you make smart financial decisions when it comes to saving for your financial goals and managing your debt.
Now, roll up your sleeves for a deep dive into APY vs. APR:
APY refers to the total amount of interest you earn on a deposit account each year. You may not think of yourself as a lender, but if you have a deposit account, you are. The bank is essentially paying you for lending them money. Bank accounts that are often associated with an APY include:
APY is based on an account’s interest rate, and it also factors in how often the interest compounds. Justin Pritchard, an independent financial planner with Approach Financial in Montrose, Colorado, says one of the big differences between APY and APR is that APY takes compounding into account. (APR only shows the annual interest on an account, not whether the interest compounds or not.)
If you’re trying to answer the “what is APY?” question, understanding how compounding works is key. On some deposit accounts, interest compounds daily, meaning interest gets added to your account’s principal balance one day, and the next day the interest rate applies to that new principal balance. With other deposit accounts, interest may compound monthly, quarterly or annually. The compounding effect of APY can help you accumulate wealth faster because you are effectively earning interest on your interest. Nice, right?
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For example, if you open an online savings account with a 2.10% APY, interest compounds daily and you deposit $15,000, after five years you’ll have earned a total of $1,644 in interest.1 Your total interest earned each year would be as follows:
“The magnitude of difference between APY and APR grows with more compounding periods,” says Erik Goodge, president of uVest Advisory Group in Newburgh, Indiana. “The only way APR and APY would be the same is if you were only getting paid or owed interest once per year,” Goodge says.
Once you understand “what is APY?”, it’s time to compare the APY on different accounts to help you determine how much money your savings can earn over time. If the numbers start to make you dizzy, a savings calculator can come to the rescue. The Discover savings calculator, for example, can help you determine how much interest you’ll earn each year based on APY, your starting balance and for how long you plan to save.
When shopping around for a new account, don’t call it quits after comparing only the APY. While it’s a helpful indicator of the returns you’ll get, the APY won’t take potential fees into consideration.
“Minimum balance fees, or any type of activity-related fees, like ATM withdrawals, could eat into the interest you earn,” Pritchard says. “A higher APY might not be worth it if you’re going to pay fees.”
Learning how to avoid fees or finding bank accounts that don’t charge fees could help you maximize your interest earnings. Discover’s Online Savings Account, for example, has no monthly fees for maintenance and no balance requirement.
“Minimum balance fees, or any type of activity-related fees, like ATM withdrawals, could eat into the interest you earn. A higher APY might not be worth it if you’re going to pay fees.”
Now that we’ve answered “what is APY?”, it’s time to explain APR. The APR is the total amount of annual interest you pay on an installment loan or revolving line of credit. “If you’re getting a loan, that’s usually the number you’re going to see,” Goodge says of APR.
When you’re learning APY vs. APR, note that you may see an APR associated with:
When considering a new credit card or loan option, evaluating an account’s APR can be more telling than evaluating its interest rate. While APR is based on the interest rate, it may also include some of the lender’s fees, points and other costs associated with credit, Goodge says.
Say you’re comparing two lenders that both offer $1,000 loans with a 10.00% interest rate. Lender A charges a $50 fee and adds it to your loan’s balance. Lender B does not. If you compare the APRs, Lender B will likely have the lower APR. Come again?
This is because with Lender B, the 10.00% interest rate applies to your $1,000 loan. With Lender A, on the other hand, you may pay more in interest because the 10.00% interest rate applies to the $1,050 (the loan amount plus fee) you have to repay.
When considering APY vs. APR, know that in some cases a loan with a lower interest rate but high fees could have a higher APR than a loan with a higher interest rate and lower fees.
Similar to comparing only APYs on a deposit account, comparing just the APR on a new credit card or loan may not tell you the whole borrowing story. Lenders might include different charges when making their APR calculations.
“If you’re comparing quotes from different lenders, you need to look closely to see which fees it includes,” Pritchard says.
With credit cards, for example, the annual fee may not be reflected in the APR. If you’re comparing two cards with the same APR, you’ll also want to look at the annual fee to understand your potential expense. Credit cards may also have multiple APRs depending on the type of transaction. For instance, the APR for cash advances could be higher than the one for regular purchases.
When evaluating APY vs. APR, know that a loan’s APR is calculated assuming you’ll take the entire term to pay it off. So if you’re comparing 30-year mortgages, but you plan on moving in five years, you may want to recalculate the APR taking the shorter term into consideration. You could learn that a loan with fewer upfront fees winds up being a lower cost, even if it has a higher advertised APR.
In their simplest forms, APY refers to what you earn on the cash that’s stashed in a savings vehicle, while APR refers to what you owe when you borrow.
When exploring new financial accounts, APY will be a factor when comparing different types of savings accounts, while APR will impact your terms on credit. You can think of the interest rate as a starting point for comparison as you shop for savings and credit options, as long as you keep in mind all of the variables and differences between APY and APR.
1 Assumes principal and interest remain on deposit and interest rate and APY do not change for one year. The values shown are for illustrative and informational purposes only and may not apply to your individual circumstances.
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1 “Expenditures on Children by Families, 2015,” Revised March 2017, Center for Nutrition Policy and Promotion, United States Department of Agriculture.
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