The terms ‘APY’ vs. ‘interest rate’ are often used interchangeably, but they actually mean two distinctly different things.
This article will offer clear definitions of interest rate, APY, APR, compound interest, compounding period, and other helpful related terms.
After reading, you should have a solid grasp of APY vs interest rate and how to effectively compare different saving accounts or investment options.
What is Interest & How Is It Calculated?
In this context, interest means the cost of borrowing money and the term interest rate means the percentage of the amount borrowed that the borrower will need to pay the lender.
Interest rate is expressed as a percentage of the total principal amount So if you borrowed $100 at an interest rate of 10%, you would pay $10 in interest each year until the principal is paid in full.
Interest rates are set based on a number of factors, including:
- Current supply and demand for money
- Potential risk for the borrower to default (financial institutions calculate this based on consumer credit scores)
- Inflation rate (economic conditions)
- The supply and demand for money
- Government intervention or regulation (such as the Central Bank setting interest rates by buying or selling government bonds, or usury laws (which vary by state) prohibiting the maximum interest a creditor can charge a consumer)
Interest rates can be fixed or variable.
- Fixed: The rate is the same for the entire lifetime of the loan (common for prime rates offered to creditworthy consumers).
- Variable: The rate can change over time, based on a variety of factors including prime rates, cost of funds, rate of inflation, and general conditions of the credit market.
It’s important to understand interest rates because they impact how expensive or easy it is for consumers to borrow money. When interest rates are high, it’s more expensive to borrow. This can make it difficult for consumers to start businesses, and buy homes, cars, or other durable consumer goods like furniture, appliances, or electronics. This can also delay major life events; the negative downstream effects are plentiful and painful.
Simple Interest vs. Compounding Interest
For consumer investors, compounding or compound interest is better.
Simple interest is calculated on only the principal amount, whereas compound interest is calculated on both the principal amount and the interest that the principal accumulates.
This means with compound interest you can earn money from the interest your investment accumulates. Here, you’re making money off your money. Over time, this can lead to significantly higher returns.
Here’s an example of simple vs compounding interest from a $100 investment at an interest rate of 5%.
- Simple interest: You would earn $5 a year every year.
- Compound interest: You would earn $5 a year after the first year, then $5.25 the following year, then $5.51 in the year after.
After 20 years:
- Simple interest: You would have $127.63 off your initial deposit of $100 and have made $27.63 in interest.
- Compound interest: You would have $266.28 off your initial deposit of $100 and have made $166.28 in interest. You would have more than doubled your investment.
For the examples shared above, this assumes a compounding period of one year which is very common.
The compounding period means the frequency of compounding interest: how often interest is calculated and then added to the principal amount.
If you have a money market account that compounds interest monthly, then interest would be calculated and added to the principal amount once a month. For a daily compounding period, then interest would be calculated and added to the principal once a day.
Here are some common compounding periods and financial products offered at those compounding rates:
- Annually (once a year): CDs, Roth IRAs, some types of bonds, some types of investments
- Semi-annually (once every 6 months): CDs, money market accounts, high-yield savings accounts, some types of bonds, some types of investments
- Quarterly (once every 3 months): CDs, money market accounts, high-yield savings accounts, bonds, mutual funds
- Monthly (once a month): CDs, traditional IRAs, money market accounts, high-yield savings accounts, bonds, mutual funds, exchange-traded funds (ETFs), annuities, auto loans
- Daily (once per day): CDs, traditional IRAs, money market accounts, high-yield savings accounts, bonds, mutual funds, ETFs, annuities, credit cards (calculating how much interest consumers owe them)
As a borrower
These are some common compounding periods for different consumer investments and consumer personal loans. You can find student loans, mortgages, auto loans, or other products where interest is compounded monthly, quarterly, weekly, or at other periods based on the loan terms.
Additionally, some loans like credit cards can have 2 or more compounded periods. This means you have to pay both interest compounded daily and interest compounded monthly.
Complicating things further, for credit cards there are different kinds of APRs based on the charges made to your account. Balance transfers and cash advances will have different APR rates.
As a borrower — for credit cards or other lines of credit — this means you could have to pay interest on the interest you’re being charged. Here, you’re letting the creditor earn interest off the compound interest you’re paying.
Yikes. That scenario is only good when you’re the investor, not the borrower. And all the more reason to pay your credit card balance in full each month and pay off other lines of credit as quickly as possible.
As an investor
The compounding period for your deposit or investment can have a major impact on how much interest you earn over time. A savings account or investment product where interest compounds daily or monthly is better than one with interest compounded annually as is common with a traditional bank saving account which is why they generate such a low amount of interest.
When saving money toward a long-term goal like retirement, it’s wise to choose an investment option that offers compounding interest to grow your savings the quickest.
What is Annual Percentage Rate (APR)?
Annual percentage rate, usually referred to as just APR, is how much it costs consumers borrowing money.
APR is expressed as a percentage of the total principal borrowed and includes the interest rate as well as any fees associated with the loan.
So if you took out a loan for $100 with an APR of 10%, this means you would pay $10 in APR. This APR figure can include the interest rate, loan origination fees, and any points or prepayment penalties.
It is important to note that APR can change over time, so it is always best to check the current APR before you borrow money.
How is APR calculated?
APR is calculated by multiplying the periodic interest rate (interest charged on a loan over a specific period of time) by the number of periods in a year (compounding periods)
The formula to calculate APR is expressed as follows:
(periodic interest rate * number of periods in a year) + fees
So if the interest rate is 10% on a loan for 3 years, the APR would be calculated as follows:
(10% * 3) + fees = 30% + fees
Keep in mind that the fees that go into the APR can vary depending on the type of loan you have. A mortgage, for example, may have insurance fees, appraisal fees, loan origination fees, closing costs, or other mortgage loan origination (MLO) fees.
What is Annual Percentage Yield (APY) and How Is It Calculated?
APY means how much interest you’ll make off an investment in one year’s time. A higher APY is better for investors as it will deliver a more favorable rate of return.
Using APY allows for a single point of comparison across different products with different compounding schedules because APY refers to the total amount of interest you can earn on your investment after one year.
In this sense, APY makes it possible to compare apples to oranges, or products with a monthly compounding period to products with a quarterly compounding period.
How is APY calculated?
It takes a little math (bear with us if you hated math class in school), but the formula isn’t that hard.
(1 + r/n)^n - 1
In this formula:
- r = Interest Rate
- n = Number of compounding periods per year (weekly would be 52, monthly would be 12, quarterly would be 4, etc.)
So, if you had a CD with an interest rate of 5% that compounded monthly, the APY would be calculated using this formula:
(1 + 0.05/12)^12 - 1
Based on the calculations, that would be 5.12% in interest—or $5.12 for a $100 investment.
What is APR vs APY?
APY (Annual Percentage Yield) is used to describe how much interest is earned on a savings account or other investment for a 1-year period.
APR (Annual Percentage Rate) describes how much interest is charged to a consumer for a credit card or loan for a 1-year period.
In a nutshell, APY is what you, as an investor earn whereas APR is what you as a borrower have to pay. Understanding APY vs APR will make you a smarter consumer so you can get the best rates and save the most money.
What is blended APY?
A blended APY is what it sounds like: an APY that blends together different APY rates.
There are some deposit accounts and financial products that offer multiple interest rates over different specified periods of time. You calculate the total blended APY by dividing the total amount of interest earned on the total amount of funds over the same period of time.
As an example, you may have a deposit account with a 2% APY for the first $5,000, and then a 5% APY for balances of over $10,000.
So if you made a deposit of $10,000 in this account you could earn:
- $100 interest for the first $5K (2% of $5,000)
- $250 interest for the remaining $5K (5% of $5,000)
The total interest earned would be $350 on $10,000 invested, for a blended APY rate of 3.5%/
Common financial products with blended APYS include:
- High-yield savings accounts
- Brokerage accounts (stocks, bonds, mutual funds, and other assets)
The key takeaway is that APY means how much interest you earn on your money at the end of the year while interest rate means the cost of borrowing money.
An interest rate can be something you earn as an investor, investing your funds in a bank account, IRA, CD, or other financial product.
An interest rate can also be something that you can pay as a borrower, with different interest rates for mortgages, student loans, car loans, or other lines of credit.
As a smart consumer and a smart investor, you should shop APYs and interest rates carefully. Doing so can maximize your savings, and returns on your investment, and make it empowering and easy to understand your personal finances.