Imagine a world where banks were fully transparent with you. Sounds nice, doesn’t it? Unfortunately, there are many tactics banks use to make parts of their business look better than they are. Specifically when it comes to APR and APY.
Well today we’re going to get the difference between APR and APY. I’ll explain to you why banks use one of them for savings interest and one for loans interest in a rather misleading way. Only one letter swapped between the two, but they’re about as different as alcohol is from Gatorade.
Explanation of APR vs APY
The simple explanation of APR and APY is this:
APR stands for “Annual Percentage Rate” and does not consider compounding interest.
APY stands for “Annual Percentage Yield” and takes compounding interest into account.
So how come APR is generally associated with loans and debt while APY is used for savings accounts and CDs (Certificates of Deposit, not compact discs!)? The reason is that, because APY takes compounding interest into account, it will show a higher effective interest rate.
So, being sneaking like they are, banks use APY to describe savings accounts because it makes you feel better about the interest you’ll be receiving. APR, on the other hand, doesn’t give you the big picture as a borrower of money.
Example of APR vs. APY
Let’s say Filo the fisherman has a $10,000 loan at 10% APR for his boat. It would appear that $1000 would be paid every year if the amount on the loan did not change. But, if the loan is compounded on a daily basis instead of on an annual basis, the actual annual interest he’d pay would be $1053.
That’s a 10.53% APY vs a 10% APR.
See how this is misleading?
APY is used for savings because banks want you to see the full amount you’ll be receiving in interest. APR is used for loans and credit cards to show you a misleadingly small interest rate so the debt doesn’t seem as bad. APY is always the more accurate rate to consider.
Now, APR and APY are applicable to both savings and loans. That’s why your APY shown on your high yield savings account is higher than the interest rate shown on the same account. The “interest rate” shown is the APR. But, in the way APR and APY are used for your average Joe, they really are about as different as alcohol and Gatorade.
Alcohol vs. Gatorade
While alcohol depletes you of water in your body, Gatorade replenishes the water in your body. Seems important since scientists tell us our bodies are made up of 70% water.
Well, APR and APY are the same thing. APR depletes your bank account of water (money). APY, replenishes it. The only difference is that if your bank account is only 70% money, you’ve got bigger problems than APR. Okay, it’s not a bulletproof example but it gives you a feel for how these work.
Just think about them like interest rates, one you pay and one you earn. Keep this in mind whenever you are looking at interest rates. Make sure you compare apples to apples, APY to APY. Never make a decision about a loan based on the APR because you’re not getting the full picture!
Like what you read (or watch)? Give the blog a follow in this little box below.
Get Financial Coaching
Are you overwhelmed by debt and feel like there’s no way out? Feeling intimidated by budgeting?
I can help! I’m a financial coach trained by Ramsey Solutions to guide people in their financial lives. Set up a free consultation below and I’ll listen to your situation and guide you on the right steps forward. There’s no commitment.