APR vs APY
If someone as intelligent and genius as Albert Einstein called compound interest as the greatest force on earth, its implications in our lives, especially financial aspect of our lives, must be important. To understand the effect of compound interest, one just has to look at the difference between APR and APY to know how it affects our finances. APR is the annual percentage rate, and APY is the annual percentage yield, and most people are aware of the terms if they deal with banks or utilize credit cards. This article will highlight the differences between these two terms to demonstrate how our money works for use in the form of deposits, and how it can cause havoc to us if we have taken a loan or run a balance in our credit cards.
In the simplest of terms, compound interest means earning interest on previous interest. If you have deposited $10000 in a savings bank account and the bank gives an APR of 5%, and the bank calculates interest annually, you will earn 5% interest which turns out to be $500 in your case. If the bank calculates interest monthly, you will earn 5% for the first month and then get an interest on the principal plus the interest earned for first month and so on. At the end of the year, you will thus get $512 instead of $500. This way, it looks pleasing, isn’t it?
Now think of a situation where you are a borrower. If a credit card company claims 12% APR but calculates interest monthly, you will be charged an APY of 12.68% which is considerably higher than its APR. This is why banks do not wish customers to know the difference between APR and APY. Those who know the game treat APR as the stated rate of interest and call APY as the effective rate of interest. This is why it is necessary to calculate the difference between APR and APY if the bank or a credit card company is trying to lure you with an APR that is lowest in the market.
So whether you are looking around to get a housing loan or looking to invest in a bank, it is always prudent to be aware of the policy of the bank to calculate interest. They will always quote APR, and they never try to explain the effective interest rate. They always have different motives depending upon which side of the lending tree you are. But as a wise and alert customer, it is in your interest to be aware of the difference between APR and APY. After all, it is your hard earned money that is at stake.
Summary
APR is the Annual Percentage Rate that banks quote when you are trying to secure loan. What they do not tell you is that they also have an APY which is the Annual Percentage Yield, which is the effective rate of interest. If the bank calculates interest monthly, you could be paying substantially higher than stated APR because of compounding interest rate.