Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
― Albert Einstein
Compound interest is the most crucial distinguishing factor when it comes to the Annual Percentage Rate (APR) or the Annual Percentage Yield (APY). Compounding is done in APY, while APR involves a much more straightforward calculation. We come across these terms when looking for loans or investments, and often wonder the difference between the two and which rate should be considered when.
Annual Percentage Rate
APR is the term used to define the interest paid on credit card, mortgage or any other type of loan. It is applicable to any interest rate and is either equal to or lesser than APY. It is simple to calculate as it does not involve any complex calculations because the rate is directly employed on the money borrowed. In case the APR for your credit card is 15%, it is applied by the credit card company, everyday, on your average credit card balance, post the grace period. On looking at the credit card statement, you will notice that the 15% is divided by 365 (days in a year), which brings the daily periodic rate to 0.04109%. Thus, if you are paying off the total balance amount every month, after the 15% interest rate is applied, then you pay less compared to what you would be paying if you carry forward your balance to the next month.
Annual Percentage Yield
APY is a term used to define the interest paid in a checking, savings or any other type of interest-assuming account. Since APY also accounts for interest paid on the initial interest amount, it is always more than APR. This interest is compounded, either on a daily, monthly, or quarterly basis, this interest is added to your average daily balance. The next time when APY is calculated, the previous amount is already added to the balance and hence a higher figure derived. Thus, except when you withdraw from an interest-bearing account, your interest deposits will always be more than what was calculated the previous time.
An Example of Comparison
To help you get a better picture of the debate, let us look at an example. Assume that you have a savings account which pays you interest at the rate of 3% annually. You deposit USD 5000 in this account. On dividing 3% by 12 months, you get a monthly interest rate of 0.25%. But when you calculate interest on the amount for a year on the 5000 dollars, by applying the interest rate only once, you will get the annual interest as USD 150. However, a monthly calculation of the interest rate at 0.25% per month would give you a much higher interest on the 5000 dollars you have in the account.
You can therefore see that the interest calculated through APY is USD 152.08 and not USD 150, as calculated through APR. Another important point is that more times the APY is calculated, higher your interest gain will be. In this case it is calculated on a monthly basis and hence, the amount will be more than what you would have arrived at by calculating the interest quarterly.
From the Borrower’s and Lender’s Perspective
When you are the borrower, you are looking for the lowest possible interest rate, as you will be paying back the borrowed amount with interest. In such a case, it is important to know what the difference between them is, so that you do not end up paying a lot of interest.
Banks normally quote you the APR. As discussed earlier, this figure does not account for the compounding done monthly, quarterly or semi-annually. For example, if the bank has quoted an interest rate of 7%, it does not take into account any compounding of the interest rate. When you consider the compounding, the interest rate goes up by 0.23%, which you eventually end up paying on your loan amount every year. This emphasizes the fact that is vital to ask your lender which rate is he charging you.
The lender (bank in this case) will always hope that the individual opens an account and saves money with the bank. This is the reason that banks quote APY when you look to open an account with them, as this rate is higher and hence would lure you towards the bank. They will seldom quote the APR as this rate is lower than the APY, provided the amount is compounded few times during the year. You should know the difference between them so that you open an account which will pay you the highest interest.
Thus, understanding this distinction will help you make smarter borrowing and saving decisions. Even if you have weak financial knowledge, you cannot be fooled, once you know this difference. Use your knowledge and calculate the interest rate on savings or borrowings, to get the actual picture.