What is APY?
Annual percentage yield is the rate of return a savings deposit or investment will earn over the course of 12 months.
APY includes compound interest — that is, interest earned by the interest itself — so it's considered an accurate way of calculating the growth of money kept in a savings vehicle or investing account.
U.S. banks must include APY when advertising interest-bearing accounts in order to give customers a true picture of what their money will earn in a year.
Interest rate vs. APY
The interest rate you earn on a deposit determines your APY, but the two are not the same thing.
An interest rate is simply a percentage of your deposit or investment that your returns will be based on, while APY factors in the effect of compound interest.
So for a savings account, for example, APR provides a more complete view of how your money will grow on an annual basis.
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What is APR?
When borrowing money, annual percentage rate is what the loan costs you in interest and other expenses during one full year.
With credit cards, your APR is simply the interest rate.
But with a mortgage, your APR factors in not only the interest but also "discount points,", broker fees, some closing costs and other charges.
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The difference between 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, while mortgage interest is often compounded monthly.
Making decisions based on 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.
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