Understanding the Difference Between APR and APY

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When people use the scary ‘I’ word in conversation, it’s usually when they talk about loans and lines of credit. In this context, interest represents how much you must pay on top of what you borrow. 

But interest is more complicated than that. It also represents what you earn on top of what you save when you sock away your hard-earned dollars in a savings account or investment fund.

The financial world separates these concepts by using two common acronyms: APR and APY. Let’s dive in to see how these terms differ.

APR on Loans: It Tells You the True Cost of Borrowing

APR is short for Annual Percentage Rate, which lenders share when they list the stats on their loans, mortgages, or credit cards. This three-letter acronym represents the annualized cost of borrowing money, which is a pretty important figure to know before you try to get you the money you need from a loan. 

APR provides an estimate of the total cost of borrowing over a year, expressed as a percentage. It includes the interest rate and any upfront fees, closing costs, or other costs the lender may charge.

This holistic view of your costs makes it easier to compare different loan options. After all, you won’t have to measure each lender’s long list of fees and interest charges. Instead, you can look at just the APR.

While APR is a useful tool, it doesn’t account for compounding interest or the effects of inflation. As a result, it might not provide an accurate representation of the true cost over multiple years or for investments involving compound interest.

APY on Savings: It Tells You What You’ll Earn on Investments

APY stands for Annual Percentage Yield, and it applies to savings and investment accounts. It reflects the potential return on an investment, giving you an idea of what you’ll earn on top of your deposits.

APY calculates the total interest earned on your investments or savings deposits. Unlike APR, it considers both the interest rate and the frequency of compounding interest to provide a more accurate estimate of the actual returns you can expect.

Why is compounding interest important with savings? Compounding interest means you’ll earn interest on the previous interest earned, as well as your principal. Over time, compounding interest will help you grow a larger emergency or retirement fund. 

If you are looking to grow your savings or investments, APY is something you should consider carefully. The compounding effect can significantly impact your overall returns, especially for long-term investments.

Key Difference between APR and APY:

Let’s recap: interest is a big player in the game of finances, as it influences how much money you’ll pay or earn on top of loans and savings.

The key difference between APR and APY lies in their focus. APR primarily focuses on the costs of borrowing, while APY emphasizes the returns on investments. 

Bottom line? Since an APY tells you how much you expect to earn, you want to clinch a high APY. And because an APR refers to how much you expect to pay, you want to borrow a loan with the lowest APR available to you today.

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