APR Vs. APY: What’s The Difference?

When evaluating loan options or potential investments, there are many terms that might make your head spin if you’re not versed in finance. There may be no better example of this than APR versus APY.

APR stands for the annual percentage rate and consists of the total amount you owe on a specific loan, such as a mortgage, including interest. APY, or annual percentage yield, is a measure of how much interest your money earns via savings or investments.

Contrasting APR And APY

Both APR and APY are interest calculations, but they’re used for different purposes. While APR measures the interest paid when you take on a loan, APY measures interest earned on savings or other investments. We’ll also get into some of the math, but it may be best to use a calculator.

APR Defined

Annual percentage rate (APR) measures the interest you pay on a loan or line of credit, including all fees and closing costs associated with the application and processing. In contrast, your monthly payment is based on a base interest rate that doesn’t factor in the total costs associated with the loan.

Because fees are factored in, APR will always be higher than the base loan amount. All else being equal, you should be looking for the lowest APR possible. This is also a good way to judge the fees associated with a loan. The bigger the difference between the base rate and the APR, the higher the closing costs and other fees.

How To Calculate APR

Calculating APR gets a little complicated. Mortgage loans have a somewhat different APR equation than what works for smaller loans. The following is a basic APR calculation followed by the steps taken to get there.

To give an idea of a basic APR calculation, let’s take the example of a $5,000 personal loan with $400 in fees and $3,000 paid in interest over a 3-year term. The equation above looks complicated, but let’s break it into steps.

1. Add together the fees and interest. For this example, that comes to $3,400.
2. Divide that number by the principal. That comes to 0.68.
3. Divide that result by the number of days in the term. Since it’s 3 years, that comes out to 1,095 days. The division should give you a really long and small decimal.
4. Now that you have the daily rate, multiply by 365. That should come to about 0.2267.
5. Multiply by 100 to convert to a percentage: 22.67% APR.

This formula works well on small loan amounts. It tends to be high when calculating APR for bigger money amounts like mortgages where things are structured differently. In addition to the things we’ve spoken about in the above formula, the APR for your mortgage is also influenced by factors including the following:

• Rate changes: If your rate is going to change because it’s an adjustable-rate mortgage or you have a temporary buydown, that influences the rate.
• Payment changes: This comes into play if you have mortgage insurance that comes off at some point.
• Upfront charges financed into the loan: As an example, FHA and VA typically have upfront charges associated with their loans, but these may be built into the loan amount.

Your best bet here is Excel’s rate function with the following arguments.

• Number of periods: This is the number of months of payments you would have over the course of the loan. For example, there are 360 months in 30 years.
• Monthly payment: For the function to give the correct result, you want to put a negative sign in front of this because it represents an outflow from your budget every month.
• Present value: For this variable, you’ll want to take your principal and subtract your total closing costs.

The solution will give you the monthly rate, which you’ll want to multiply by 12 to get the APR. We would show the math here, but it’s a nonlinear equation where the program goes through several iterations to get the answer based on the Newton-Raphson method.

Let’s be honest. No one came here for calculus. (Please don’t come at me if that’s not actually calculus. I went through Algebra II.)

APY Defined

Annual percentage yield (APY) tells you how much interest you can earn over the course of a year by leaving your money in a particular investment or account. The reason the APY is higher than the base interest rate you see is because it takes into account compound interest.

Each time you earn interest, that gets added to the balance and you’re earning interest on a higher balance with each compounding period. So more money is made over time than if the balance remained flat for the period of the investment.

APY is associated with savings and money market accounts as well as other longer-term investment vehicles like certificates of deposit (CDs). Unlike APR, because you’re earning the money, it’s to your advantage to find as high an APY as possible.

How To Calculate APY

Calculating APY is much simpler. You just need two inputs, the base interest rate, also referred to as the nominal interest rate, and the number of times the interest is going to compound. Here’s the formula:

As an example, let’s calculate the APY for an investment that compounds daily with a 4% interest rate. Let’s run through the order of operations to give you an idea of how to do the math here. I would say to use “Please Excuse My Dear Aunt Sally” as the mnemonic, but I have an Aunt Sally who is lovely and doesn’t need to be excused for anything.

1. Parentheses (or in this case brackets) first. Within those brackets, division first. Because you’re dividing 4 by 365, this should be a really small number.
2. Next add 1.
3. Raise the whole thing to the power of 365.
4. Subtract 1.
5. Multiply that result by 100. Your APY is 4.081%

APR, APY And Your Mortgage

Because APY is about earned investment income, it really doesn’t apply to mortgages. Maybe investors care about their yield, but this has no impact on a borrower. On the other hand, APR is a big deal because it defines how much you can expect to pay in fees and closing costs.

When you’re shopping for a mortgage, the bigger the difference between the base interest rate and your APR, the more you can expect to pay in closing costs and other fees associated with the loan. But there are instances in which it might make sense to opt for a higher APR if you’re saving money in the long run.

Buying mortgage points can allow you to save money over the long run on the loan by lowering your monthly payment. The key is to make sure you’re going to be in the home or mortgage long enough to realize the savings. One point is equal to 1% of the loan amount. A rate with no points is considered the par rate.

If you pay $3,000 in points, but save $30 per month on your payment, that means you’ll have broken even after 8 years, 4 months. Every month you’re in your home after that, you’re saving money on your mortgage payment.

APR Vs. APY FAQs

We’ve broken down the topic, but let’s answer some more questions.

Can you compare interest rates for APR and APY?

Although they both measure amounts of interest, you wouldn’t typically be able to compare the two because they’re used for two different things. APR is a measure of the overall interest you can expect to pay on a loan. APY is the yield you can expect from a savings account or investment.

Where are APR and APY applied?

APR is applied when doing the math for loans and lines of credit to determine how much you’re going to pay in interest and fees. This would be applied for everything from personal and car loans to mortgages and credit cards. On the other hand, APY is about earning. You would see it when trying to figure out the effect of compound interest on savings accounts and CDs.

Why do banks use APY instead of APR?

Banks would actually use both of these interest rates depending on whether they were doing the lending or making interest payments into an investment vehicle like a money market account. If you had a mortgage or loan through them, they would have to show APR to show the costs. If it was a savings account, they would show the APY with the effects of compound interest.

How can you find a good APR or APY?

The key to finding a good APR or APY is to shop around. In general, you want the lowest APR possible unless you’re paying more in closing costs to save you money in the long run, as you might with mortgage points. APR is just the opposite. The higher the APY, the better the impact of the compound interest.

The Bottom Line

While they’re both interest rates, APR and APY are very different. APR measures the total cost of a loan or line of credit, including fees and closing costs. APY is the interest rate you can expect to earn on a savings account or other investment product because of compound interest. Generally, you want a lower APR and a higher APY.

While you can compute APR and APY in theory, it may be far easier to use a specialized calculator or spreadsheet function. The math is a little wonky, particularly when it comes to mortgages. Shopping around can help you get the best rates for your situation.

If all this has you feeling more comfortable, you can get started with a mortgage application from our friends at Rocket Mortgage^®.