Balancing Act

A question came up recently about the difference between APR and APY. While the distinction is seemingly subtle the difference can have a big impact on your money.

Simply put, APR or Annual Percentage Rate is the annual rate of interest charged without compounding. So an APR of 12% is 1% per year. APY or Annual Percentage Yeild is the interest rate compounded throughout the year.

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Investopedia.com has this to say about the difference between APR and APY:
For example, a credit card company might charge 1% interest each month; therefore the APR would equal 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest. The APY for a 1% rate of interest compounded monthly would be [(1 + 0.01)^12 – 1= 12.68%] 12.68% a year. If you only carry a balance on your credit card for one month’s period you will be charged the equivalent yearly rate of 12%. However if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of the compounding each month.

So if you are the lender, it makes sense to quote interest in terms of APR. It just sounds better to say that you are being charged 7% APR instead of telling you the consumer that you are really being charged 7.23% APY.

The lowdown on all this financial mumbo jumbo is to look at the APY to know what you are really being charged on a loan. This will help you compare rates and keep the price of the loan down low.