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When looking for a loan or making an investment, you will most likely encounter words like APR and APY. Even if you are not in the financial investing field, you have taken out a loan and signed a loan agreement that includes a clause concerning APRs (Annual Percentage Rats). So then, what is an annual percentage yield (APY)? Though these two abbreviations appear similar at first glance, they contain substantial differences other than one letter. Therefore, it is critical to understand the distinctions between these two notions. Continue reading to learn more about the APR and APY and how they differ.
APR: What Is It?
Applying for the loan, you will be charged interest for borrowing the principal amount. The interest rates and APR seem similar; however, the difference is that the APR includes all the costs associated with the loan throughout the year.
APR is used with borrowings such as credit cards, personal loans, home equity of lines, and credit types. The annual percentage rate is the interest you will be charged when you borrow. Lower APRs are interpreted as cheaper loans. Thus, the borrowers need to compare the APRs of the loans before applying for one. Besides, the borrowers should know the difference between fixed and variable APRs.
A fixed APR is the fav tool of budgeters as it stays unchanged during the loan's lifetime. Thus, the borrowers will always know the rates beforehand with fixed APRs.
Variable APR makes monthly expense planning more difficult as the interest changes over time. However, this change can be linked to the prime rate (the lowest commercial interest rate at which money can be borrowed).
There are also various APRs, such as purchase APR, the cash advance APR, penalty APR, and promotional APR.
The penalty APR is as it sounds: you pay the penalty for late payment. It is one of the highest APRs in your loan agreement. Your interest rate rises every time you miss a payment. Borrowers should carefully study the credit card agreement to see whether there is a penalty APR.
Purchase APR is the interest added when purchasing with a credit card. The purchase APR is subject to change with 45 days' notice.
Cash advance APR is the cost of using your credit card to borrow money. Some credit card transactions (such as purchasing lottery tickets or casino chips) may sometimes be referred to as cash advances, even though they do not involve cash withdrawals. The cash advance APR has no grace period; therefore, the interest is applied immediately.
A promotional APR is the lowest APR applicable on your credit debt for a set time. The introductory rate is generally only valid for your credit card for the first few months after you obtain it.
APY: What Is It?
The APY, also known as the EAR (Effective Yearly Rate), combines your annual interest rate and the interest compounding rate. APY/EAR is frequently given to savings and money market accounts funds. Remember that the APY takes into account not only interest but also compound interest.
Compound interest is the interest earned not only on your money but also on the interest gained on the money. Since compound interest rises quicker than simple interest, you can make more money.
The compounding of interest runs annually, monthly, or daily depending on your scheme. Then the earned interest is applied to the principal amount of your loan, saving account, or investment account. Be informed that you will make more with daily interest compound than yearly. It is because your finances and APY are closely connected, and the higher the APY, the higher the amount you earn. To help you understand more the APY, let's look at the following example:
Suppose you deposit $300,000 into your savings account at a monthly compound interest rate of 1%. You will receive $300 the first month but $303 the following month, and the interest will continue to rise as long as you maintain your money in the account.
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The APR and APY both relate to interest; however, the APR refers to the interest you pay, while the APY refers to the interest you earn. Another distinction is compounded interest; as previously stated, the APY includes compounded interest, whereas the APR does not. Finally, the APR cost consists of all charges connected with the loan during its lifespan. In contrast, the APY cost includes the interest plus compounded interest earned by putting money into your bank account or investing.
For example, if your interest rate is 4%, multiply 12 by 4. Remember that extra costs are applied to this total. On the other hand, APY raises the periodic rate plus one to the power of yearly periods minus one. There are online calculators available to assist you in making precise calculations.
Conclusion
Understanding APR and APY and their differences can help you remain on top of your money. For example, a higher APY will earn you more money in an investment or savings account. At the same time, a higher APR on loans may be regarded as paying more. The borrowers should also remember that the APR is higher than interest rates, as it incorporates all the additional charges, such as loan origination fees. Thus, whenever shopping for a loan, compare the APRs before choosing one credit type.
The APY, on the contrary, should be higher to earn more money. So, you can look into numerous institutions that provide compounded interest savings accounts before choosing one.
Remember that the quantity of money in your account, not only the APY, may affect your earnings.