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Why APY Matters And The APR Lies

by The Happy Rock on March 28, 2008

bank-springfield.jpgAPR and APY. I know that I have had to look up the difference more than once in my life. It is one of those facts that is easy to understand, but they easy to forget. The numbers are usually similar, but the subtle difference can cost you a lot of money. So, what do they mean and what is the difference.

Annual Percentage Rate(APR) is the rate that a company assigns to the financial product. If a credit card has a 12% APR that means that will mostly like charge 1% a month for 12 months. If you carried a $10,000 balance on a 12% APR credit card, the simple interest would be $10,000 * 12% or $1,200 dollars in interest for the year. Seems simple enough, but what about the APY.

Annual Percentage Yield is the actual rate that you receive at the end of the year after taking into account compounding interest. Banks and lenders don’t use the simple interest formula they use compound interest. Using the compounding method on the same $10,000 balance on a 12% APR credit card, you would pay $100($10,000 * 1%) in interest the first month. The next month you will pay $101($10,100 * 1%) in interest the second month, $102($10,201 * 1%) the third month and so on until the end of the year. This compounding will actually cost you $1,268.25 interest rather the $1,200 you would have thought. That difference is the displayed in the APY. 12% APR compoudning monthly is 12.68% APY.

Earning interest on interest works for you when saving, but against you when you borrow money. Lenders will try and show you the APR, while savings vehicles will show you the APY. Either way FOLLOW THE APY.

{ 3 comments… read them below or add one }

PT March 28, 2008 at 12:59 am

An easy to follow explanation of the APY vs APR. Thanks for sharing. I like your rule of thumb at the end too.

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spillingbuckets March 28, 2008 at 8:06 am

Thanks for this post, it really makes things easy to understand. I never really thought about the difference in the two but am glad you explained it.

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Family Vacations April 4, 2008 at 11:45 pm

Follow the APY. I’ve got to remember that! I’ve never really understood the difference. Thanks for giving such a great explanation.

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