APR vs APY: Understanding the Difference
When comparing savings accounts, certificates of deposit (CDs), or loans, you'll often see two acronyms: APR and APY. While they look similar, they measure different things.
What is APR?
Annual Percentage Rate (APR) is the simple interest rate charged or earned over a year. It generally does not account for compounding interest within that year.
What is APY?
Annual Percentage Yield (APY) represents the actual rate of return you will earn because it does take compounding into account. Essentially, APY pays you interest on your interest.
Why APY is Higher
Because expected interest payments are added to your balance throughout the year, the base for future interest calculations grows. This creates a "yield" that is higher than the simple "rate."
The Formula
The standard formula for converting APR to APY is:
APY = (1 + r/n)n - 1Where:
r = The annual interest rate (APR) as a decimal (e.g., 0.05 for 5%)
n = The number of compounding periods per year