APR vs. APY vs. Interest Rate

This article will discuss three commonly confused terms: APR,  APY, and Interest Rates. These terms are often incorrectly used interchangeably, but today we will break down the key differences so you can understand what they mean and when to use them.

What do APR and APY stand for?

APR = Annual Percentage Rate

APY = Annual Percentage Yield

What are the differences?

Interest Rate

Interest Rates can be thought of as the pure percentage rate that a loan will be charged or earn in interest. You will be charged this rate in interest if you are borrowing money, and you will earn this rate in interest if you are lending money. This rate does not consider any up-front costs or other fees.

APR (Annual Percentage Rate)

APR is the more comprehensive cost of borrowing. Unlike interest rates, the APR includes up-front costs and fees. 

Consider Jim buying a new car. Jim gets a 10% interest rate on a $20,000 loan for five years. Jim’s monthly payment would be around $425. 

Let’s say the bank that gave Jim his loan charges a $500 fee for creating the loan. Jim now effectively is only being lent $19,500, yet his monthly payment stays the same! Using a fancy financial formula that factors in this fee over the lifetime of the loan, it turns out that Jim is not paying the promised 10% in interest, but rather an APR of 11.16% since he is paying the same monthly payment for less money.

Although it may seem complicated, APR is actually a great tool when comparing different loans since it tells the entire story. APR is arguably the best metric to compare different loans side-by-side.

APY (Annual Percentage Yield)

APY is the total interest return an investor would receive, assuming that they re-invest any interest earned within a 12-month period at the same interest rate the account is earning.

For example, if the interest rate on a savings account was 2% and it compounded monthly (meaning interest was paid out monthly), and the investor kept all her money in the account, the actual yield earned over 12 months (the APY!) would be approximately 2.02%. To learn more about the power of compounding, read our article, “Compounding: the 8th Wonder of the World.”