Whether you’re borrowing money or saving it, the interest rate matters. Interest, put simply, is the cost of temporarily using money belonging to someone else. When you lend money, you earn interest, and when you borrow, you pay it.
Of course, you want to pay the lowest interest—or get the most out of your investment. But the interest rate doesn’t tell the whole story. When comparing rates for loans, credit cards, savings products—or any financial product—it’s important to delve a little deeper.
Meet APR and APY. Short for Annual Percentage Rate and Annual Percentage Yield, these represent the true cost of borrowing or the real return on your investment.
APR: The Basics
The APR tells you the amount of interest you’ll pay on borrowed money, from mortgages to credit cards to car loans, over a one-year period. The APR starts with the interest rate, and adds on account points, loan costs and additional fees.
Therefore, your APR generally is higher than your interest rate. And the higher the APR, the more money you will pay in interest each year. As with APY, financial institutions are required to list the APR for consumers to review, so that they can, in a sense, allow you to compare apples to apples.
The APR varies by the type of credit account. An APR for a mortgage loan could have closing costs wrapped into it. A credit card can have more than one APR as well, depending on whether you use your line of credit for everyday purchases or cash advances, for example.
Your lender can tell you what factors have been included in the APR when you borrow money.
Tip: When shopping for a mortgage, compare the APRs between loan options and terms. A 15-year mortgage will almost always offer a lower APR than a 30-year mortgage.
APY: The Basics
APY is the amount of interest you earn on money you deposit into savings or money market accounts, or put into a term account (also known as a CD, or certificate of deposit), over the course of a year. As with the APR, the interest rate is just the starting point. How often interest is compounded is also figured into the APY.
If you are considering two or more accounts for your savings, it pays to compare the APY on each for the full picture on how much your money can earn over a year.
What is the significance of the APY? In its simplest form, the higher the APY, the more money you earn. If you have $25,000 invested in a one-year term account with a 2.86% APY, at the end of the year, you will have earned $715. With a 2.50% APY, your return would be $625.
You may see a higher APY on accounts that have a higher minimum deposit and a longer commitment for how long you must keep the money in the account. Be sure to familiarize yourself with the terms and conditions of any account you open.
Let’s take a closer look at compounding interest.
Compound interest simply means earning interest on interest. When interest compounds daily, your interest is broken into 365 smaller payments. When it compounds monthly, it is paid in 12 payments. If interest is compounded daily, interest added on Tuesday will earn interest on Wednesday, and then the new amount will earn interest on Thursday—and so on. If interest is added monthly, the interest earned for a specific month will be paid once each month.
While it is true that the more often interest is compounded, the more you stand to earn, it’s important to remember that when looking at APY, you are looking at the annual yield, not the rate. That means, when you see a savings account that advertises 2.00% APY, you will have earned 2.00% on your balance by year end, whether it is compounded daily or monthly: APY is the equalizer and allows you to compare apples to apples.
Now, let’s look at credit cards and compounding interest. The APR on a credit card is irrelevant if you pay off your card balance each month within the issuer’s grace period, which typically is 28 to 31 days.
If you can’t pay off your card balance each month, the interest charges can accrue quickly. Credit cards use your average daily balance when they assess interest, so every day that you owe money to the credit card issuer will affect the interest you pay each month.
If you make only the minimum payment each month, the amount of interest you’re paying means it could take months—even years, depending on the balance—even if you make no other charges.
Tip: Pay your credit card bill as early in the month as you can if you carry a balance. Waiting until the date it is due means you will pay higher interest. And once you’ve made the minimum payment for the month, making an extra payment will help to lower the average daily balance. Take that $20 you saved by using coupons buying groceries and put it toward your credit card. You will notice a difference in interest payments at the end of the month by using both of the strategies.
APR and APY can seem like a complex topic, but it has a simple bottom line: The higher the APR, the more you’ll pay; the higher the APY, the more you’ll earn. Your choice of a loan, credit card or savings account could impact your finances for years to come.
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