APY vs APR: How Are Interest Rates Used In Finance?

by Debbie D. on 2011-11-141

Understand rates, returns and terms in order to make the right product choices in finance.

APR, APY, effective APR, nominal APR and interest rate. We see these terms pop up a lot when we talk about finance. They should all be part of our personal financial vocabulary, but are all these terms referring to the same thing?

Depending on whether you are looking for the highest rate of return on your investment or savings account, or you’re shopping for a loan, credit or mortgage product, these terms can mean different things. Understanding them is necessary to compare different financial products, say for knowing how much you’re paying for credit or knowing what your expected rate of return will be on savings or investments.

Let’s take a look at each of these financial terms and how they relate to the products they’re used with: mortgages, loans, credit cards and investments.

Use Interest Rates (APY vs APR) To Choose The Right Financial Product

#1 Dealing With Mortgages

Shopping for a home is exciting –- comparing mortgage products? Not so much. There are so many more factors to consider besides what interest rate you’re paying when comparing one mortgage loan with another to find the most cost effective option. But we’ll start with interest.

Mortgage lenders will quote the annual percentage rate (APR) on their loans. APR includes interest rate and fees and is a standard calculation used by all mortgage lenders in an effort to help borrowers compare various mortgage products. If you were comparing basic interest rates only, you may think that the loan with the lowest stated interest rate is the best value, but in some cases, a loan with a higher interest rate but lower fees ends up being the most cost effective option. When comparing mortgage loans, you need to compare the APR of one product to another as it will include all fees into the rate.

Banks generally quote the APR, which does not take into consideration the effects of compounding. Some mortgage loans may compound every six months, some every three months, and some will compound monthly. The frequency of compounding greatly affects the amount you pay compared to the APR that the lender will quote you.

Bank Quoted APR Compunded Semi-Annually Compounded Quarterly Compounded Monthly
5.00% 5.06% 5.09% 5.11%
7.00% 7.12% 7.19% 7.23%

When shopping for a mortgage, you will want to ask lenders how frequently they compound interest. If they say “monthly”, then expect them to quote you the APY, which takes into consideration the effect of monthly compounding, since the difference in percentage rates between the APR and APY will make a big difference in the amount you pay over a loan amortized over 30 years. Ask your lender how frequently they compound, and then you can use an APR to APY calculator to determine the amount of interest you’re actually paying. Enter the APR in the APR text box or field and leave the APY field blank. Enter the frequency the loan will compound, and then click convert! You can also do the reverse. Here’s a calculator that does both conversions.

As mentioned, comparing mortgage loans requires more than a comparison of interest rates. You also need to consider “Points” that you pay in exchange for a lower interest rate. Each point is equal to 1% of your total loan amount. You also need to compare the loan origination fee charged by lenders. For example, if your lender charges a 1% lender origination fee, you can expect to pay $1,480 on a $148,000 loan at closing.

Only when you take all of these factors into consideration can you accurately compare one mortgage product against another to find the most cost effective option.

#2 Dissecting Your Credit Cards & Their Interest Rates

Changes to credit card legislation has made credit card statements slightly easier to understand than in previous years. You should now see at a glance what your APR is for purchases, balance transfers and cash advances. It should be easier to see any other fees your card is charging you per month and how much you’ve paid in the last year.

On your credit card statement, you may see multiple APRs listed, which can be confusing. In the Interest Charge Calculation section of your credit card statement, you can have up to 3 different APRs for the difference balances. When you use your credit card to pay for something, that’s a “purchase” transaction. The interest you pay on your purchases is displayed on this line of your statement. It may be a fixed rate or a variable rate.

You will also see a line for balance transfers and how much interest you pay on money you have transferred from other accounts. The APR for balance transfers may be the same or different from your purchase rate APR.

Finally, you will also see a line for cash advances and the amount of interest you pay for taking money out of an ATM from your credit card. Cash advances normally have the highest APRs of all the various balances, and you should avoid them at all costs.

The problem with credit card statements is that the APR you see is the annual rate of interest paid, without considering the effects of compounding interest during the year. It works out fine if you pay your balance in full each month or never carry a balance for longer than a month at a time, since the APR is the interest you pay in that scenario. If you pay 1% interest per month, the APR is 12% (1% x 12 months in a year = 12%) and you can easily figure out how much your credit card debt costs you during the month.

The APR is not a complete picture of the costs of the debt if you carry a balance on your credit card from month to month. For example, if you carry a balance for one year, your 12% APR becomes an effective interest rate of 12.68% (the APY) due to compounding interest.

Here’s how to calculate the effective interest rate, or the APY:
(1 + 0.01)^12 – 1 = 12.68% APY

The APY is the amount you’re actually paying on your credit card debt if you carry the balance over the course of a year.

#3 Paying Interest On Other Loans

When applying for a student loan, car loan, personal loan — or any kind of loan, really — chances are good that the bank will intentionally quote the APR. The APR will make the loan appear less expensive than it really is. If the APR is quoted as 10% on a loan product, then you’re paying 10% more on the money you borrow as interest, and that would be the equivalent of paying .83% each month. The .83% interest paid per month is called the “period rate”.

Loan interest rates are compounded over the course of each year, which means that you need to determine what the APY is on a loan product to understand how much you are really paying.

Here’s the formula to figure out the APY:
APY = (1 + period rate) ^ (periods per year) – 1

But it’s easier to use an online APR to APY calculator! Enter the interest rate that the loan quotes you in the APR field, leave the APY field blank, and enter 12 in the box to figure out the APY on a loan that compounds monthly. In our example, the loan quoted as 10% APR is actually 10.47% APY.

#4 Scrutinizing Your Savings and Investment Returns

When saving or investing money in hopes of earning a return, it pays to shop around to find the highest interest rate savings options or investment accounts. The problem is, interest rates can be shown in two different ways — either the APR or the APY — and it can be a little confusing when you try to figure out an expected rate of return. Not only do you need to know what the APY for savings products are, but you need to know how frequently the interest is compounded in order to make an accurate comparison and to choose the account which will earn you the most.

Note, however, that when discussing savings vehicles and products, the rates involved these days aren’t really anything to brag about. The lower the rates, the smaller the differences are when results of compounding frequency are compared. So for instance, if you are looking at a savings account that’s offering 5.1% interest compounded annually versus another that pays 5% interest compounded daily, you won’t really find much of a difference here. Now if you’re looking at much higher levels of interest (which are typically found on loan products), then this is where you may want to be careful about making these comparisons.

Bottom line: When we understand the different terms used to describe interest rates for various financial products, we can compare different investments or the actual cost of borrowing money more effectively.

Created April 4, 2007. Updated November 14, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 1 comment… read it below or add one }

Susan Shaw November 14, 2011 at 10:05 pm

Thanks for discussing the impact of (and difference between) daily, monthly and annual rate compounding. This should be one of the first things to have in mind when shopping for loans or accounts.

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