APY and APR – do you know the difference? Your bank does…

What do APY and APR mean?

APR is short for “annual percentage rate” while APY means “annual percentage yield”. Although they sound very similar there is a significant difference between them – at least signficant enough for a bank to tell you the APY when applying for a savings account and the APR when applying for a loan or a credit card.

Now what is the difference?

The APR is the annual rate of interest and doesn´take into account compouding of interest (which means earning interest on interest which you have earned previously) during the whole year. The APY does take compouding into account. While this might seem to be not more than a minor difference it can in fact be very important for your bank and for yourself.

APY and APR compared

For example you want to get a new credit card: Bank A offers a card with an APR of 12% while bank B offers you an APY of 12.68%. What do you think is better? Which bank would you choose? Most consumers of course want the interest to be as low as possible. And so the would choose bank B with seemingly smaller annual interest. But is bank A´s offer really better? Let´s take a closer look: Both banks charge interest monthly (as it is absolutely usual for credit cards). This means that bank A charges 1% interest monthly (12% divided by 12 (as compounding is not taken into account)).

Would you believe me that bank B also charges exactly 1% interest per month – and nothing more as their APY of 12.68% compared to bank A´s APR of 12% might suggest? If you believe this, you are right.
When you know the monthly interest i you can calcculate the APY the following way:

APY = ((1+i)^12)-1
APY = ((1+0.01)^12)-1 = 0.1268 = 12.68%

As you can see: When paying interest monthly an APR of 12% is equal to an APY of 12.68%. And know you are able to understand why a bank might prefer to tell you either the APR or the APY – depending on which financial product you want to apply for. If you want a credit card they will tell you the APR as the interest will seem to be lower this way. If you want a savings account you want a higher interest. So telling you the APR would not make sense for them, because the APY will make the interest rates look better.

So what to do?

When comparing different offers from different banks you should always take a very close look at small details. As you have seen above a single letter (Y or R) can make a big difference. Ask the banks for both – the APR and the APY – and ask if interest is paid/charged annual, semi-annual, quarterly or monthly. Don´t think the banker wants what is best for you. The only thing he wants is your money.