Introduction
When using financial products, you might have come across two important acronyms, APY and APR. Both have become an essential part of our financial vocabulary, but many people are not aware of the differences between the two. In this article, we are going to understand the meaning of APY and APR and how they are calculated.
What is APY?
APY stands for 'Annual Percentage Yield.' It is the rate of interest that you earn on a financial product in one year, taking into account compound interest. In simple terms, compound interest is the interest earned on the interest that you have already earned. The formula for APY is:
APY = (1 + (r/n)) ^ n - 1
Where:
- r is the annual interest rate
- n is the number of compounding periods in a year
When you invest money into a financial product with a fixed APY, you earn interest that compounds over the year. The interest earned is automatically reinvested into the account, where it starts earning interest again. The longer the money remains in the account and the higher the APY, the more interest you will earn.
What is APR?
APR or 'Annual Percentage Rate' is the interest rate charged on a loan or debt over a year. APR is a single percentage number that represents the total cost of borrowing money. APR does not take into account compounding. Instead, it applies a simple interest rate to the principal amount borrowed. The formula for APR is:
APR = (Interest Paid/Amount Borrowed) * 100
Where:
- Interest Paid is the total amount of interest paid over the year
- Amount Borrowed is the principal amount borrowed
The APR includes any fees and charges associated with the loan, which gives a better representation of the total cost of borrowing compared to just the interest rate. By law, lenders are required to disclose the APR of a loan before agreeing to any terms.
Differences between APY and APR
APY and APR are frequently confused with one another, but they are different in their applications. Here are some key differences:
- APY is the interest earned on an investment, while APR is the interest paid on a loan.
- APY takes into account compound interest while APR does not.
- APY calculates the interest earned over a year, while APR calculates the cost of borrowing over a year.
- APY is always higher than APR since APY accounts for compounding interest.
Conclusion
APY and APR are essential terms to understand when dealing with financial products. Both are represented by a percentage but have different applications. APY is the interest earned on an investment while APR is the interest paid on a loan. APY takes into account compounding, while APR does not. Understanding the difference between the two can help investors and borrowers make better financial decisions.
