When comparing interest rates that a bank offers on a mortgage, home equity line of credit, car loan, credit card, certificate of deposit, or savings account, it’s important to know exactly what rate you are looking at.
Even a 0.5% difference in interest rate could cost you hundreds or thousands of dollars when compounded over years.
This post will serve as a quick primer on interest rate terminology and calculations.
What is Annual Percentage Rate (APR)
Annual percentage yield, or APY, is the effective interest rate, with compounding factored in. For that reason, it is also referred to as the effective APR, or EAR.
Banking institutions have deposit products that compound over various periods – daily, weekly, monthly, annually, etc. They are required to express interest rates in the form of APY, or EAR, so that you can compare rates between institutions.
It is essentially the real rate you are are effectively receiving or paying, when compounding is factored in.
How to Calculate APR and APY
APR = Periodic rate x number of periods in a year
For example, a credit card with a 1% monthly interest rate would have a 12% APR (1% x 12 = 12%)
APY = (1 + nominal APR/n)^n – 1
n = the number of compounding periods per year.
nominal APR is expressed in decimal format (i.e. 12% = 0.12)
For example, a credit card with a 12% APR, compounded monthly, would have an EAR equal to 12.68%. The equation would be (1 + .12/12)^12 – 1 = .1268 = 12.68%
If the credit line compounded daily, the EAR equation would be (1 + .12/365)^365 – 1 = .1274 = 12.74%
Why APY is Important
In any borrowing or investment scenario that involves compounding and/or fees, you want to know what the EAR (APY) is.
In a mortgage or loan scenario, you’ll want to know what the EAR is after closing or other fees are factored in.
In a credit card scenario, companies will often quote you a nominal APR (annual percentage rate). However, since your balance compounds monthly, you do not end up paying the nominal APR. Due to the compounding, your EAR will be higher.
Knowing EAR allows you to compare apples to apples and make precise calculations.
APR vs. APY Discussion:
Do you ever feel like you were misled by a bank or credit card company when only being presented with APR vs. APY?
source: 20somethingfinance.com
