You can count on a bank or lender to emphasize whichever of the two will seem more enticing to you. Here's why understanding the difference between APR and APY is important.
First, a quick lesson on compound interest
Compound interest is a powerful force. It makes your savings— or a debt — grow more quickly by applying interest to the interest already earned or charged.
Let's say you earned 5% interest last year on $100. Your account would have grown to $105. Through compound interest, you'd earn 5% on $105 the following year, rather than on the original $100.
Interest can be compounded — that is, calculated and added to a savings or debt balance — on an annual, quarterly (every three months), monthly or daily basis.
When interest is compounded more frequently, it can result in a mountain of debt, versus manageable debt. Or, your savings can grow much more quickly.
What this means for APR and APY
The difference between APR and APY is that APR doesn’t take compound interest into account, but APY does.
APR is the annual or yearly rate of interest, without compound interest factored in. APY builds the compounding into the rate.
A savings vehicle or loan might have an APR of 5% but an APY of 5.09% if the interest is compounded quarterly, or an APY of 5.11% if the compounding is done monthly.
Banks tend to compound the interest on savings accounts on a monthly or daily basis. Mortgage interest is often compounded monthly.
Know: Is it APR? Or APY?
A mortgage lender who's trying to get you to sign up for a home loan will make the interest rate sound as low as possible — which means you're more likely to be presented with an APR instead of the APY. Always ask what the APY is.
Meanwhile, when a bank wants your deposit for a savings account, you can expect to hear the savings APY upfront, because it will be higher and so will sound better than the APR.
As you evaluate loans and savings products, make sure you’re comparing APY to APY, or APR to APR, and consider the frequency of compounding.
This all may sound complicated, but all you have to do is remember: when interest is compounded more often, you'll earn — or pay — more.