APR vs APY: What’s the Difference and Which One Should You Choose?

When it comes to your money, it’s crucial that you are as clear as possible about what you’re getting. That’s where the annual percentage rate (APR) and annual percentage yield (APY) come in.

Defining APR & APY

APR is the yearly cost of borrowing money expressed as a percentage. It includes the interest rate you’re paying on the loan and associated fees. APY, on the other hand, is the yearly amount of interest that you would earn if all of your deposited funds remained deposited at the stated annual percentage rate. In other words, APY considers both the interest rate and compounding frequency.

Practical Example

It’s easy to see why APY is a more accurate representation of what you’ll actually earn (or pay) on a loan. With APR, you only see part of the picture.

Here’s an example:

Say you’re considering a 12-month certificate of deposit (CD) with a 2% interest rate and monthly compounding. The CD has no fees associated with it. Using the formula for APR, we get:

APR = 2% / 12 months = 0.1667%

Now let’s calculate the APY for the same CD using the formula:

APY = (1 + 0.02/12)¹² — 1 = 2.08%

As you can see, the APY is higher than the APR because it includes compounding. In this case, the difference is not significant, but in other situations, it can be.

When comparing investment options, be sure to look at both the APR and the APY to get a true picture of what you’ll earn (or pay). And remember, the higher the APY, the better.

Bottom Line

APR and APY are both measures of an investment’s cost (or earnings), expressed as a percentage. APR only considers the interest rate, while APY includes the effect of compounding. As a result, APY is always higher than APR. When comparing investment options, be sure to look at both numbers to get a true picture of what you’ll earn (or pay).

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