APR Vs. APY: Understanding Credit Card Interest Rates
When comparing credit cards, you may come across the terms APY and APR. Although these acronyms sound similar, they are very different in how they describe interest. For starters, Annual Percentage Rate (APR) refers to interest owed, while Annual Percentage Yield (APY) indicates interest earned.
Here’s a guide to APR and APY, how they work, and how they’re different.
What is APR?
APR refers to the amount of interest you will pay annually on a loan or credit card. This does not mean that you will pay your credit card or your loan once a year. Typically, you will make a monthly payment.
the Truth in Lending Act, which protects consumers against unfair lending practices, requires lenders to disclose the APR in advance. This is because the APR is supposed to show the actual annual cost of borrowing money, which includes lender fees and other fees in addition to interest rates. For example, mortgages often come with origination fees, points, and other fees that are factored into the APR.
But, when it comes to credit cards, the APR and the interest rate are the same. Although your card may have annual fees or charges for late payments, balance transfers, etc., card issuers generally do not include these charges in the APR. It’s just too difficult for credit card companies to predict what charges you’ll incur or how often you’ll incur them.
How does APR work?
As mentioned, the APR is the simple interest rate charged to a borrower over one year. So if you buy a laptop for $1,000 using a credit card with an APR of 20%, your account balance will be $1,000 and you will have to pay $200 interest over 12 months, which equals $16.66 per month.
However, you will probably end up paying more because the APR does not show the effect of compound interest. Most credit card issuers accrue interest charges daily if your account has a balance. The issuer calculates your daily interest rate by dividing your APR by 365.
This means that interest is added to your account each day based on its average daily balance. The more your balance increases, the more interest is added to your balance each day. Conversely, the more your balance decreases, the less interest is added to your balance.
Fortunately, you can usually avoid paying interest on credit card purchases by paying your account balance in full each month before the due date. Another way to get around interest charges is to transfer your debt to a balance transfer credit card with a 0% APR for a set period. Additionally, a credit card with an initial APR of 0% may be worth considering if you have larger purchases in mind and want to avoid interest while you pay them off.
What is APY?
While APR is used to describe the interest you will pay on loans and credit cards, APY refers to the interest you will earn on your savings over a year. The term APY, often referred to as Annual Earned Rate or EAR, is commonly used by banks and investors to indicate your rate of return on savings and deposit accounts. In this case, you are the “lender” and the APY lets you know how much your money is earning in interest.
Unlike APR, APY takes compound interest into account. However, APY does not include any fees as this would lower the rate of return making it harder for banks and financial institutions to attract more investors.
How does APY work?
APY takes into account how often your savings or investment account is compounded with this formula:
APY= (1 + r/n )n – 1.
“R” refers to the declared annual interest rate and “n” is the number of compounding periods each year.
But, if you don’t want to do the calculations yourself, a compound interest calculator could save you time.
A savings account or a deposit account can be funded daily, monthly, quarterly or annually. Generally, the more often your account adds compound interest, the faster your investment grows. This is because each time your account accrues interest, the interest earned is added to the principal amount and future interest payments are calculated on the larger principal balance.
If you are comparing savings or investment accounts, it pays to compare their APYs and not just their interest rates. It may seem that one account is a better investment because its interest rate is higher than another account. However, if this second account accumulates more frequently, it may exceed the first account during the year.
APR versus APY
APR and APY both measure interest, but they have different uses. APR describes the interest you owe on a credit card or loan, while APY measures the interest you earn on an interest-bearing savings or deposit account, such as a savings account, CD or money market account.
The most significant difference between APR and APY is that APR does not take into account compound interest, while APY does. APY refers to interest on your deposit plus compound interest. In contrast, the APR value for installment loans only includes interest plus potential fees. There is no difference between the APR and the credit card interest rate.
The bottom line
Whether you’re comparing credit card offers or opening a savings account, a good understanding of APR and APY can help you make more informed decisions with your money. And if you need help, Bankrate has plenty of credit card calculators to help you out.
If you’re considering a credit card offer, pay attention to the APR – a lower rate means you’ll pay less interest. Remember that annual fees and other fees are not included in credit card APRs, so be sure to read the fine print to determine if the fees are likely to offset the card’s benefits.
The reverse is true with APY. The higher the rate, the more interest you will earn on your deposit. And if you’re comparing savings accounts, pay close attention to how often your interest is compounded to better understand how much your money will earn you.