What Is the Difference Between APY and APR?
Grasp the fundamental difference between APR and APY. Uncover how these distinct financial metrics impact your money's true cost or growth.
Financial terms like Annual Percentage Rate (APR) and Annual Percentage Yield (APY) often appear when discussing loans, savings, and investments. Understanding the distinction between these two rates is important for making informed financial decisions. While both relate to interest, they apply in different contexts and convey different information about the cost of borrowing or the return on savings, helping consumers assess financial products more effectively.
Understanding Annual Percentage Rate (APR)
Annual Percentage Rate (APR) represents the yearly cost of borrowing money. This rate includes the nominal interest rate and certain loan fees, such as origination fees or discount points on a mortgage. APR provides a comprehensive picture of a loan’s cost over a year, allowing for easier comparison between lending products. For instance, a credit card might have an APR around 20%, reflecting the annual cost of carrying a balance.
APR is primarily used for credit cards, mortgages, and auto loans. It typically does not account for the effect of compounding interest within the year, assuming simple interest calculation. For example, new car loans in early 2025 averaged 6.73% APR, while used car loans averaged 11.87%.
Understanding Annual Percentage Yield (APY)
Annual Percentage Yield (APY) reflects the real rate of return earned on an investment or savings account over a year, taking into account the effect of compounding interest. Compounding occurs when earned interest is added back to the principal balance, allowing future interest to be calculated on a larger sum. This “interest on interest” effect can significantly increase the total return over time.
APY is commonly applied to savings accounts, certificates of deposit (CDs), and money market accounts. When interest is compounded more frequently than annually, the APY will always be higher than the stated nominal interest rate. For example, high-yield savings accounts can offer APYs ranging from 4.15% to 5.00% as of August 2025.
Key Distinctions and Consumer Impact
The fundamental difference between APR and APY lies in the inclusion of compounding interest and their primary application. For borrowers, a lower APR is generally more favorable, indicating a lower loan cost. For savers, a higher APY is always preferred, signifying greater earnings on their deposits.
Compounding frequency is the core element that differentiates the effective rates. Interest can be compounded daily, monthly, quarterly, semi-annually, or annually for both loans and savings. For savings accounts, interest is often compounded daily, which means the APY will be notably higher than the simple interest rate. Even a small difference in compounding frequency can lead to a significant difference in total earnings over time.
While APR on loans often does not directly reflect compounding in its stated figure, interest on loans can still compound, typically monthly for most consumer loans. Credit card interest charges, for instance, are frequently compounded daily. If a balance is carried, the effective cost of borrowing can exceed the stated APR due to this frequent compounding. Therefore, understanding the compounding schedule is crucial to ascertain the true cost beyond the headline APR. For savings, comparing APY across different accounts provides the most accurate measure of potential earnings.