The world of banking and investing can be a confusing place, with numerous acronyms and terms that sound the same but mean different things. One such pair of terms is APR and APY. But while APR and APY may sound the same, they are quite different and understanding them is important when making investments.
APR stands for Annual Percentage Rate. This is the rate of interest that you pay on something like a loan or credit card. It is the interest rate that you agree to pay as part of the original contract. It is the rate of interest that is charged without any compounding, and is the amount of interest required to pay off the loan in one year.
APY, on the other hand, stands for Annual Percentage Yield. This is the rate of interest that you earn on investments like savings accounts and certificates of deposit (CDs). Most loans and investments use a compound interest rate to calculate interest. compound interest is interest that is added to the principal amount of a loan or investment, and then works to earn more interest. So, it can be more beneficial to have an investment with a higher APY than an investment with a higher APR.
Banks and credit unions offering the best CDs pay higher APYs or dividend rates. For instance, if you invest the same $1,000 in a six-month CD, one bank might offer a 2.50% APY while another bank might offer a 3.25% APY. The bank offering 3.25% will earn you more interest over the six-month period.
When you look to open a savings account or something similar like CDs, you quickly learn that not every bank offers the same interest rate. That's why it's important to shop around and compare rates to get the best deal. Because each CD in your ladder has its own investment amount, term and interest rate, you'll need to run the CD rate calculator for each CD in your ladder to decide if the APY is worth the investment.
The interest rate and the APY for a deposit account may be the same or different. If the interest rate stays the same, the APY stays the same. However, when interest compounds, the APY is usually higher than the interest rate. That's what makes it such a powerful tool for investing, as compounding can make a small difference in interest rate add up over time.
The same calculation can also be useful for inflation, which is the rate at which the prices of goods and services increase. To calculate the amount of time it takes to double your money with a given rate of interest, you can use the rule of 72. Years to double = 72 / rate of return on investment (or interest rate).
Understanding the difference between simple and compound interest can also help you to understand the difference between APR and APY. Simple interest applies a fixed rate, meaning that the interest remains the same for the lifetime of the loan or account. compound interest, however, is interest that is added to the principal amount of the loan or investment, and then works to earn more interest.
APY includes the effects of compound interest, while APR does not. Both protocols could have the same APR, but the APY can vary wildly based on how often interest is compounded. It's important to understand the difference between APR and APY and how they affect the investments you make.
