APR vs APY: What’s The Difference?

APR, or Annual Percentage Rate, is an annualized representation of the cost of borrowing or the annual yield of an investment, without the effects of compounding. Annual Percentage Yield (APY), on the other hand, takes into account not only the nominal interest rate but also the effect of compounding.

When it comes to managing finances and understanding various financial terms, APR and APY are two crucial concepts that often perplex many individuals. They both represent interest rates, but they serve different purposes and can have a significant impact on your financial decisions. 

In this article, we will delve deep into the differences between APR and APY, unraveling their meanings, applications, and importance. 

What is APR vs. APY?

APR stands for Annual Percentage Rate, and APY stands for Annual Percentage Yield. Both are financial metrics that represent interest rates. APR is used to calculate the annualized interest rate charged on any form of credit, including not only the interest rate but also certain additional fees charged by lenders. On the other hand, APY is the total return you earn on an investment over a year, taking into account both the interest rate and the effect of compounding.

For a clear understanding between APR and APY in investments, see the image below, which compares how a hypothetical $1,000 investment would grow over time with a 5% APR vs a 5% APY.

Comparison between a compounding $1,000 investment and a non-compounding $1,000 investment.

Understanding APR in detail

In the following sections, we’ll explore APR in greater detail and understand its significance in various financial transactions.

APR is commonly used for various types of credit products, such as:

• Mortgage loans
• Auto loans
• Personal loans
• Credit cards

APR is also used in investments and interest-bearing accounts, where it is used to represent investment growth without the compounding effect.

APR calculation formula

To comprehend how APR works, it's essential to know the formula used to calculate it. The standard formula for APR calculation is as follows:

APR = (Total Interest Paid / Loan Amount) x (365 / Number of Days of Loan Term) x 100

APR and credit cards

When you use a credit card, the APR becomes particularly important. The APR on credit cards can be fixed or variable, depending on the terms and conditions of your card agreement.

Understanding APY in detail

Next, let's explore APY and why it matters in the realm of investments. APY is primarily used for the following financial products:

• Savings accounts
• Certificates of Deposit (CDs)
• Money market accounts

APY calculation formula

APY calculation takes into account the interest rate and the frequency of compounding. The formula to calculate APY is as follows:

APY = (1 + (Interest Rate / Number of Compounding Periods)) ^ Number of Compounding Periods - 1

The power of compounding

One of the significant factors contributing to APY's importance is the power of compounding. Compounding allows your investment to grow faster over time as the interest earned also earns interest.

If we return to the image shown earlier in the article, the difference between the compounding and non-compounding model is stark. By “Year 20”, a $1,000 investment compounding with a 5% annual return would grow to $2,527. In the same period, a $1,000 investment with a 5% APR would grow to just $1,950.

APR vs APY: Key Differences

In this section, we'll draw a clear comparison between APR and APY, highlighting their primary differences. You can compare the main differences between the two in the table below.

	APR	APY
Definition	Annual percentage rate	Annual percentage yield
What it measures	The total yearly cost of borrowing money, expressed as a percentage, and includes the interest you pay on a loan.	The total amount of money you earn on a savings account or other investment, taking into account compound interest.
When it is used	Typically used for credit accounts, such as loans and credit cards.	Typically used for deposit accounts, such as savings accounts and certificates of deposit.
How it is calculated	APR is calculated by adding the interest rate to any fees that are associated with the loan or credit card.	APY is calculated by taking the interest rate and compounding it over the course of a year.
Which is higher?	APR is typically lower than APY.	APY is typically higher than APR, but it can vary depending on the frequency of compounding.
Which is more accurate?	APR is more accurate for short-term loans.	APY is more accurate for long-term loans and savings accounts.

As you can see, there are significant differences between APR and APY, so investors and borrowers should be very cognizant of the two concepts when taking out a loan or investing in stocks, crypto, real state trusts, or any other financial instrument. With that said, let’s examine the difference between APR vs APY in more detail: 

• Nature of calculation: The key distinction lies in how APR and APY are calculated. APR is a simple interest rate, whereas APY takes compounding into account, resulting in a higher effective yield.
• Application in finance: APR is typically used in credit and loan products, while APY is employed in various interest-earning investment accounts.
• Representation of costs: APR represents the cost of borrowing and includes fees, while APY reflects the earnings on investments.
• Impact on borrowers and investors: APR impacts borrowers as a higher APR means higher borrowing costs. On the other hand, APY benefits investors, as a higher APY means more significant returns on investments.

APR vs APY in real-life scenarios

To better understand these concepts, let's see how the annual percentage rate and annual percentage yield apply in simple real-life situations.

Real-life scenario 1: Credit card debt

Imagine you have two credit cards with balances of $5,000 each. Card A has an APR of 18%, and Card B has an APR of 22%. Both cards have minimum monthly payments of $100.

In this scenario, Card B with the higher APR would cost you more in interest payments over time, making it more challenging to pay off the debt compared to Card A.

Real-life scenario 2: Investment earnings

Suppose you invest $10,000 in two different accounts. Account X offers an APY of 5%, compounded annually, while Account Y provides an APY of 4.75%, compounded quarterly.

In this case, Account X would yield higher returns due to more frequent compounding, even though both accounts have a marginal difference in APY.

Real-life scenario 3: APR vs APY in crypto

Let’s assume you are using a DeFi product that allows you to earn 20% APR on your 10,000 USDT investment. After one year, you’ll have 12,000 USDT, a year after that, $14,000, and so on. 

Meanwhile, a different DeFi product allows users to earn 20% APY. After one year, you’ll have 12,000 USDT, the same as when using the DeFi product with a 20% APR. However, in year two, the second DeFi product will push your capital to 14,400 USDT, surpassing the APR product’s profits by 400 USDT.

The bottom line: APR and APY serve different purposes, but they are both very important financial concepts

Understanding the difference between APR and APY is essential for making informed financial decisions. In basic terms, APR influences the cost of borrowing, while APY impacts the returns on investments. Whether you are taking out a loan or planning to invest, having a clear grasp of these concepts will help you manage your finances effectively.

If you want to learn more about financial concepts, we suggest you check our examination of the differences between dividend rate and annual percentage yield (APY).

To calculate the rate of return of your crypto investments, try out our crypto profit calculator, which allows you to set initial investment value, contribution frequency, and other relevant parameters to see how your crypto investment might grow over time. You can also use the tool to calculate the rate of return for other  assets besides crypto – just make sure to enter your custom parameters correctly.