When comparing financial products online, we often see percentage rates under acronyms like APR and APY. Many Canadians assume this is just the interest rate. However, the annual percentage rate (APR) is for interest owed, and the annual percentage yield (APY) is for interest earned.
The annual percentage rate, most commonly referred to as APR, is the interest you will pay annually on a loan. APR could be for a mortgage, car payment or credit card.
The ‘annual’ in ‘annual percentage rate’ doesn’t mean that you only pay your loan once a year. You are likely paying it monthly or an even more frequent payment schedule, depending on the loan.
APR differs from simple interest because it includes a number of fees on top of the interest rate. This is why you will see different numbers when you compare interest rates and APR. If the APR is significantly higher than the interest rate, you know you are paying a lot of extra fees.
One of the biggest things to note with APR is that it does not consider compound interest. While APR does include many fees, it doesn’t include everything. So, while APR is advertised as the true cost of borrowing, it’s not all-encompassing and will likely be lower than the amount you need to pay back on an annual basis.
» MORE: How are mortgage rates set?
Several free online calculators will allow you to figure out the APR but if you want to do it yourself the old fashioned way, here’s how you can calculate APR:
[((Fees + Interest paid over the life of the loan)/Loan amount)/Number of days in the loan term) x 365] x 100 = APR
1. Combine the fees and interest paid over the life of the loan to determine the total cost for the borrower
2. Divide that cost by the loan amount, which is the total funds borrowed.
3. Divide that by the number of days in the loan term
4. Multiply that figure by 365
5. Finally, multiply that number by 100 to determine the annual percentage rate.
Let’s say you borrow $100 for 30 days. Interest is $2, and there is an additional $1 fee. If you paid back the entire amount within the 30 days, your APR would be calculated as:
[((3/100)/30) x365] x100
=[(0.03/30) x 365] x 100
= [0.001 x 365] x 100
Note that if you did not include the $1 fee, the interest rate would have been 24.33%. But, as you can see, the interest rate increases quite significantly by adding in the fee.
Whereas APR is used for the interest you owe on loans, annual percentage yield, or APY, is used for the interest earned on savings over a year. For this reason, you also hear this number referred to as earned annual interest (EAR).
APY is used mostly by banks or other financial institutions to tell clients how much interest they earn on their principal. You will frequently find this number on any savings accounts. The higher the APY, the more money you will make.
Your best bet for a high rate is to look at high-interest savings accounts. And, if you’re comfortable locking away your money, you can earn a higher-than-usual rate of interest with a guaranteed investment certificate (GIC).
Unlike APR, APY does account for compound interest. However, APY does not consider any fees, as it is in the bank or financial institution’s best interest to have this number appear as high as possible to win your business.
Again, there are free online calculators to figure out the APY. However, if you want to do the math yourself, then you can calculate APY by using the following equation:
APY= [(1 +(interest/ number of compounding periods)^ compounding periods] -1
So, if we have $100 deposited for one year at 5% interest and that is compounded monthly your APY would be calculated as:
So your APY is 5.12%. Now, this doesn’t seem like a big increase of over 5% — but remember that interest will continue to compound, and you will earn more over time.
APR and APY are two important terms to understand regarding interest rates, but one is not better than the other as they are used very differently. APR is for interest owed and APY is for interest earned. While both claim to be true reflections of money owed or earned, as indicated above, both leave out some fees.
Whereas the goal for APR is to make the cost of borrowing look as small as possible, banks and financial institutions want to make the earnings on your savings look as high as possible with APY. The main goal for both is to make the financial product, whether it be a loan, credit card, or savings account, look as attractive as possible to the prospective client.
Even though these numbers are not perfect, both adequately determine overall interest than the regular interest rate, so it is worth your time reading the fine print and learning more about these numbers when shopping around for financial products.
Hannah Logan is a writer and blogger who specializes in personal finance and travel. You can follow her personal travel blog EatSleepBreatheTravel.com or find her on Instagram @hannahlogan21.