• APR is a measure of how much a loan will cost, while APY is a measure of how much a deposit is expected to earn.
• An APY takes compounding interest into account — while APR does not.
• Generally speaking, one should seek the lowest APR offered and the highest APY available.
While they are essentially two sides of the same coin, annual percentage rate (APR) and annual percentage yield (APY) are in fact two very different things. APY indicates how much one could pay, while APY is a calculation of the amount one could earn.
An annual percentage rate is a calculation of the potential interest a borrower would pay on credit card debt; car, personal and home loans; lines of credit; and home equity lines of credit.
In a nutshell, the term APR is a measure of the cost of borrowing money.
It should be noted that in some cases, the APR could also include lender fees, closing costs and insurance if those expenses are rolled into the financing of the deal. This makes the APR a more precise measurement than the interest rate alone.
The lower the APR a borrower is required to pay, the better. So, a good APR is the lowest one offered. The lower the APR, the lower the annual interest payments, and the higher the APR, the more the borrower will be required to pay in interest on the loan.
An APR is calculated by multiplying the interest rate by the number of times a year the rate is applied. For example, if the rate were applied weekly, one would multiply the rate by 52. In an instance in which the rate is applied biannually, one would multiply the rate by two.
As an example, a situation in which a credit card issuer charges 1% interest on each monthly balance makes the effective APR 12%.
The annual percentage yield (sometimes also referred to as effective annual rate or EAR) refers to the amount of money a financial institution will pay a depositor for use of the depositor’s capital. The term is usually employed in reference to savings accounts, money market accounts, certificates of deposit and interest-bearing checking accounts.
Simply put, it is the amount of interest a deposit could earn in a year.
However, unlike an APR, an APY considers interest compounding in its calculation, in addition to how often interest is compounded over the course of a year. Generally, the higher the frequency of compounding, the greater the earning potential. This makes the annual percentage yield a more accurate estimate of the earning potential of a deposit than the interest rate alone.
In the simplest terms, compound interest is interest earned on interest payments, which are then added to the principal amount of the deposit — or the loan. Ideally, an investor will seek to maximize compounding on investments and minimize it on borrowed funds.
As an example, consider a scenario in which an investor deposits $100 in an account paying an APY of 10%. All other things being equal, the deposit will earn $10 in interest payments at the end of the first year.
That $10 is added to the $100 principal amount and interest will be calculated on the $110 balance the following year — rather than just the $100 initial deposit. Interest will continue to accrue in this fashion (compound) each year (annually) until the account is closed.
The higher the APY, the more interest a depositor will earn on their money. Therefore, all other things being equal, the best APY is the highest annual percentage yield a depositor can find.
The equation for the calculation of an APY is a bit more complicated than that for an APR because one must take compounding into account. Thus, an APY is calculated by adding 1+ the periodic rate as a decimal and multiplying it by the number of times equal to the number of periods that the rate is applied, then subtracting 1.
As an example, consider a CD that pays 1% monthly. Unlike the credit card example above, the interest is also compounded monthly. Therefore the APY would be 12.68%, rather than 12%:
[(1 + 0.01)^12 – 1 = 12.68%].
A borrower seeking a home loan might be attracted to a product quoting an annual percentage rate of 5%. Remember, though, the APR is simply the quoted interest rate multiplied by the number of times it is applied each year. However, the borrower must also be careful to ensure that quote takes the earned annual interest into account.
Considered from that perspective, a 5% APR could really turn out to be 5.11% if the rate is applied monthly. While that might appear to be a nominal figure at first glance, it will become quite substantial when multiplied over the 30 years a mortgage is typically repaid.
This makes asking a lender how the rate is applied an important question.
On the other side of the equation, when one is depositing funds with a bank, they are more likely to get APY quotes than APR quotes, as the former will be a larger number. The key here, however, is to determine how often compounding occurs. This is what will make the difference when comparing offers from a variety of banks.
Whether borrowing or depositing, there are some important questions to ask about both the APR and the APY before committing to a financial product.
• Compounding frequency: How often compounding occurs has a direct effect on the amount a deposit will earn, as well as how much a loan will cost.
• Fixed vs variable interest rates: An introductory credit card rate can be a strong enticement. However, rates often inflate significantly once an introductory period ends. Meanwhile, APYs are often tied to the fund’s rate and can go up or down in sympathy.
• How the APR is applied: The methods by which an APR is applied to purchases vs cash advances on credit cards can vary significantly. Cash advances usually incur at a much higher interest rate than purchases.
Investors are often apprised of the advantages of money market accounts as useful tools for portfolio diversification. While their annual percentage yields do tend to be on the lower side when compared to more aggressive investment vehicles, they do hold the potential to earn interest on funds for which there could be an immediate need.
Generally, liquidating certain types of equities can be a cumbersome process when compared to savings accounts. Because they are easily converted back into cash, money market products can introduce diversification to a portfolio while also providing ready liquidity.
Alternative investments can also be potentially useful tools for portfolio diversification, which is generally agreed upon by experts to be a smart investment strategy to pursue. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification.
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Ultimately, the primary difference between APR and APY is that an APR applies when one borrows, while an APY applies when one lends in the form of a savings account, money market account or a certificate of deposit.
When considering an APR, it is prudent to seek the lowest one available, while getting the highest one available should be the goal when looking at an APY. This is because the APR determines what will be paid and an APY determines what will be earned.
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