This posting is on one of the finer point of interest: the difference between APR and APY. You might be thinking that interest calculations are boring – and you’d be right, but in this case understanding the difference affects the amount of cash in your pocket.
APR is the Annual Percent Rate or the simple annual percentage paid on something. For a credit card, its usually 23% or for a 12 month CD its about 2.5%. According to the Consumer Credit Protection act of 1986 this has to be displayed in bold on every consumer loan agreement.
APY is the Annual Percent Yield, also known as the effective interest rate.
Wait, you say, what is the difference between APR and APY? Good question. The difference between the two has to do with the rate of compounding. The APR assumes that your interest compounds once per year. The APY can be compounded, daily, weekly, monthly or whatever.
Lets illustrate with an example:
Assume you borrow a thousand dollars at 6%.
The APR would be .06 * 1,000 or $60, assuming that you compounded once per year.
The APY would be (1 + .06/12) 1,000 or $61.68, assuming that you compounded once per month.
The distinction is subtle, but understanding it can impact your bottom line. For example, many credit card companies will advertise their APR, but instead will compound your card balance using an APY that adjusts daily. This means that you will be paying marginally more than you think based on the cards advertised APR. Typically the amounts are small, but hey – small leaks sink big ships.