Interest Rate, APR, and APY: What’s the Difference and Why Does It Matter?

Interest rate, APR, and APY are often confused

Interest rate, APR and APY are all terms lenders and other financial institutions use fairly often. They may sound similar but there are key differences you should know as the differences will affect how much you earn/pay when applied to your balance.

Let’s look at the main differences and why they matter.

Interest rate: Refers simply to the annual cost of a loan to a borrower (expressed as a percentage).

APR (Annual Percentage Rate): The APR includes the interest plus fees. For example, if taking on a mortgage, the APR will include fees like closing costs, discount points, and loan origination fees. (1) Because all institutions are required by law (Truth in Lending Act) (2) to disclose the APR and follow the same procedures to ensure accuracy, it’s a good way to compare loans between lenders. APR does NOT however consider compound interest, which is why most financial lenders will reference this calculation; the rate seems lower for loans including credit cards, personal loans, and mortgages.

APY (Annual Percentage Yield): The APY DOES take into consideration the compounded interest (3). The APY is not always shown for loans because it will depend on a number of factors including monthly payments and early pay-off penalties. APYs are more often advertised for assets such as savings accounts or CDs. Without sounding too cynical, the APY is typically advertised for money earned vs. borrowed because it will always show a higher number due to the compounding interest.

Before we go any further, let's define compound interest

Compound interest is the interest on a loan or investment calculated using both the principal PLUS the accumulated interest. To calculate compound interest, apply this formula (3):

APR = (1+ periodic rate) ^ # of periods -1

Let’s see how both APR and APY play out in practice:

Assume you take out a $20,000 loan with an APR of 12% (compounded monthly). With a 12% APR you pay 1% interest every month (12%/12 months = 1%/month). In month 1, your interest will be 1% of $12,000 or $120. The new balance on your loan (assuming no other payments were made), is the original principal of $20,000 + $120 = $20,120. In month 2, your interest rate will be calculated off the $20,120, not the original $20,000 which displays the effects of compounding interest.

I want to take on a loan-what should I ask?

Now that you know the difference between APR and APY, let’s make sure you’re armed with the right questions before applying for a loan.

  1. Always ask for the interest rate and the APR; you’ll need the APR to compare across lenders.
  2. If they have not already, ask the lender to disclose the delta between the interest rate and the APR (remember that the APR includes the cost of the loan).
  3. Make sure you know if the interest is compounded monthly, quarterly, etc. The more often the interest is compounded, the more expensive the loan will be.
  4. If taking on a home mortgage, be cautious with adjustable-rate-mortgages as they relate to APR/APY. Because of the variability in interest, it can be difficult to predict the APY.

As always, please be sure to consult a certified financial planner or lending professional before signing any documents. There is a lot of fine print with investments or loans. Each case is unique and may require adjustments based on your financial situation so don’t be afraid to ask questions.

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