Difference between APR and APY

APR is the annual rate of interest without taking into account the compounding of interest within that year. Alternatively, APY does take into account the effects of intra-year compounding. Here is a look at the formulas for each method:

For example, a credit card company might charge 1% interest each month; therefore the APR would equal 12% (1% x 12 months = 12%). This differs from APY, which takes into account compound interest. The APY for a 1% rate of interest compounded monthly would be [(1 + 0.01)^12 – 1= 12.68%] 12.68% a year. If you only carry a balance on your credit card for one month's period you will be charged the equivalent yearly rate of 12%. However if you carry that balance for the year, your effective interest rate becomes 12.68% as a result of the compounding each month.

The Borrower's Perspective
As a borrower, you are always searching for the lowest possible rate. When looking at the difference between APR and APY, you need to be worried about how a loan might be "disguised" as a lower rate than it really is.

Banks will often quote you the Annual Percentage Rate (APR). This figure does not take into account any intra-year compounding either semi-annual (every six months), quarterly (every three months), or monthly (12 times per year) compounding of the loan. The APR is simply the periodic rate of interest multiplied by the number of periods in the year.

As you can see, even though a bank may have quoted you a rate of 5%, 7%, or 9% depending on the frequency of compounding (this may differ depending on the bank, state, country, etc), you could actually pay a much higher rate. In the case of a bank quoting an APR of 9%, this does not consider the effects of compounding. However, if you were to consider the effects of monthly compounding, as APY does, you will pay 0.38% more on your loan each year - a significant amount when you are amortizing your loan over a 25- or 30-year period.

The Lender's Perspective

Now as you may have already guessed, it is not hard to see how standing on the other side of the lending tree can affect your results in an equally significant fashion, and how banks and other institutions will often entice individuals by quoting APY. Just as individuals who are seeking loans want to pay the lowest possible rate of interest, the same individual wants to receive the highest rate of interest when they themselves are the lender.

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