APR vs. APY: Understanding credit card interest rates

When comparing credit cards, you may encounter the terms APY and APR. While these acronyms look similar, they are very different in the way they describe interest. For starters, annual percentage rate (APR) refers to interest owed while annual percentage yield (APY) shows interest earned.

Here’s a guide on APR and APY, how they work and how they are different.

What is an APR?

When most people see the term APR, they usually think about the total amount of interest that will be paid each year on a loan or credit card. Although interest is a component of an APR, that isn’t always the whole story.

The Truth in Lending Act, which protects consumers against unfair lending practices, requires lenders to disclose the APR upfront. That’s because APR is meant to show the actual annual cost of borrowing money, which includes lender fees and other charges in addition to the interest rates. For example, mortgage loans often come with origination fees, points and other charges that the APR considers.

When it comes to credit cards, however, the APR and the interest rate are the same. While your card may come with an annual fee or charges for late payments, balance transfers and the like, card issuers generally don’t include these fees in the credit card APR. It’s simply too difficult for issuers to predict which fees you will incur or how often you will incur them.

How does an APR work?

As mentioned, when it comes to credit cards, an APR is the simple interest rate charged to a borrower over a year. So, if you purchase a $1,000 laptop computer using a credit card with a 20 percent APR, your account balance will be $1,000, and you’ll be charged $200 in interest over 12 months. However, you’ll likely end up paying more because APR doesn’t show the effect of compounding interest.

Most credit card issuers compound the interest charges daily if your account carries a balance. That means interest is added to your account every day based on its average daily balance. The greater your balance grows, the more interest is added to your balance each day. This also means that you end up paying interest on interest. Conversely, the more your balance decreases, the less interest is added to your balance.

Fortunately, you can usually avoid paying interest on credit card purchases by paying your account balance in full by the due date each month. If you want to avoid interest while paying off a large purchase, a credit card with a 0 percent introductory APR may be worth considering. Transferring existing debt to a balance transfer credit card with a 0 percent introductory APR is another way to avoid paying interest for a period of time.

What is an APY?

While APR is used to describe the amount of interest you’ll pay annually, APY refers to the amount of interest you’ll earn over a year. Sometimes referred to as an earned annual rate (or EAR), an APY is commonly used by banks and investors to state the total rate of return you’ll receive on savings and deposit accounts. In this case, you are the “lender” and the APY lets you know how much interest your money is earning.

Unlike APR, APY takes compound interest into account. However, APY doesn’t include any fees. One reason this may be is that doing so would drag down the return rate, making it harder for banks and financial institutions to attract more investors.

How does an APY work?

APY considers how often your savings or investment account compounds with this formula:

If you don’t want to run the math yourself, a compound interest calculator could save you time.

A savings account or deposit account may compound daily, monthly, quarterly or annually. As a rule, the more often your account adds compound interest, the faster your investment grows. That’s because each time your account compounds interest, the earned interest is added to the principal amount, and future interest payments are calculated on the larger principal balance.

If you’re comparing savings or investment accounts, it pays to compare their APYs and not just their interest rates. At first glance, it may appear that one account is a better investment because its interest rate is higher than another account. However, if the second account compounds more frequently, it may outgrow the first account over the year.

APR vs. APY

APR and APY both measure interest, but they have different uses. APR describes the interest you owe on a credit card or loan, while APY measures the interest you earn from a savings or an interest-earning deposit account — such as a savings account, CD or money market account.

The most significant difference between APR and APY is that APR doesn’t take compounded interest into account, while APY does. APY refers to your deposit’s interest plus compound interest. By contrast, the APR value for installment loans only includes the interest plus potential fees. There is no difference between the APR and the interest rate for credit cards.

The bottom line

Whether you’re comparing credit card offers or establishing a savings account, having a firm understanding of APR and APY can help you make more informed decisions with your money. If you need help, Bankrate has many credit card calculators to assist you.

When considering a credit card offer, pay attention to the card’s APR. Although a lower rate means you’ll pay less interest, remember that annual fees and other charges are not included in a credit card’s APR. Make sure to read the fine print so you can determine if fees are likely to offset the card’s benefits.

The opposite is true with APY. The higher the rate, the more interest you’ll earn on your deposit. If you’re comparing savings accounts, pay close attention to the frequency that your interest compounds to better understand how much your money will earn.