What’s the difference between APR and APY?
APR and APY are two terms you come across frequently in investment and loans. Many companies will try to trick you into greater debt by giving you the APR rate and not the APY rate. We made a quick APR vs APY guide for dummies to show you how you can calculate both rates and where to use them.
Ever wonder why you know people still paying off their credit card debt from the 80s or why a 40-year mortgage can end up costing so much more than the house?
Have you been confused when you made an 8% interest investment but only got 6% returns?
As you learn about finance and investing, you’ve probably run into the terms APR and APY frequently. These two terms hold the key to all of your interest questions.
As a borrowing and investing service, MyConstant works very closely with APR and APY. We want to tell you the difference between APR and APY and how they work. So you can make informed decisions on your financial life and start earning like a pro.
What is APR?
Most investments (and loans) you make will be calculated in APR. APR stands for Annual Percentage Rate. Our friends in finance also like to call it the “nominal rate”.
The “annual” in APR means it’s the calculated rate you are growing your money over one year. If you invested $100 for 1 year with a fixed 8% APR you would earn $8 at the end of the year.
Now here’s where lots of people get confused.
APR is always calculated based on a per-year yield. So if you invested $100 at 8% APR for just 6 months you’d only earn equal to a half-year of earning at 8%. That’s $4. While you have only made 4% in 6 months, you are earning on a course to make 8% by the end of a year.
What about APR for investments lasting longer than one year?
Again, APR is calculated on a per-year basis. So if you want to calculate your earnings for, say, 2 years of 10% APR, you would simply add the APRs together.
2 years of 10% APR is 20% growth. Just remember that even though you grew 20% over two years you were still earning 10% APR. Getting the hang of it?
Investing in a MyConstant crypto-backed loan earns 7% APR on a 6-month term. That means on a 6-month investment you’re guaranteed to 3.5% on your principal. And you will get the full 7% if you invest for a second term.
We stop short of allowing a full-year term because shorter terms decrease the chance that borrowers will default. You can reinvest your principal plus earnings immediately for compounding interest.
Compounding your principal from reinvesting can add up to big earnings for you. And that brings us to APY.
What is APY?
“Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t, pays it.”
APY or Annual Percentage Yield is yearly compounded interest. In finance, it’s called the “effective rate”.
Understanding how compounding works is the key to understanding APY. When your interest compounds, you are adding the interest you earned previously to the total sum of money you are earning interest on.
Let’s break that down with the formula for converting APR to APY.
If you’re not into math skip this next part:
What is the formula for converting APR to APY?
To calculate your APY you’ll need to know:
- Your yearly interest rate
- The number of times per year your interest is compounded.
The standard equation for APY is (1+r/n)^n – 1
r = APR (as a decimal)
n = number of times funds are compounded in one year
Let’s say you earn 10% APR compounded every 2 months. That means in one year your money compounds 6 times.
Your math should look like this:
(1+(.1/6))^6 – 1
(1+.0167)^6 – 1
(1.0167)^6 – 1
1.104 – 1
Multiply that answer by 100 and you’ll get an APY of 10.4%. Now you’re starting to see the difference between APR and APY.
APY is how the credit card companies get you. They’ll give you the APR rate and tell you when it compounds but won’t give you the actual APY rate. The APR for the above is still 10% but the APY is 10.4% and that’s just for every 2 months. Credit cards can compound every day.
Let’s walk through the process without the math.
Say you earn 10% APR on $1,000 compounded every half-year. On paper 10% APR should yield $100. But here’s where compounding works its magic.
At the end of 6 months, you’d take the interest earned in the first half of the year (half of 10%, so 5% or $50) and add it to the total amount you’re earning with. So for the second 6 months, you invest $1,050 instead of $1,000. That means in the end you end up with $1,125 and your real interest rate for the year is around 10.25% APY.
As you might guess, compounding really adds up.
Here’s why compounding interest is important
To illustrate how APR and APY rates start to differ, here’s a graph of the growth of $1,000 at 10% APR over 10 years next to a graph of the same $1,000 growing at 10% APR compounding every year.
Without compounding, $1,000 earning 10% a year will yield a steady 100% return, bringing your sum to $2,000. However, $1,000 earning 10% a year with yearly compounding brings roughly a 150% return and a total sum of around $2,500.
And that’s just with compounding every year. Most interest compounds much more often than that. Imagine what $1,000 compounding every 6 months would look like.
A great way to earn compound interest today
When you deposit fiat into your instant access account you earn 4% APY compounded every second. You now know that means every second your money is on our platform it’s building on itself slowly but surely. And the longer you leave your money in the account the more you gain.
We also offer 1-6 month terms for normal fixed-term investments yielding up to 7% APR. If you reinvest your earnings at the end of each term, that rate will increase a bit every time.
APR vs APY can be a difficult concept to wrap your head around. Once you understand the two, you’ll understand what that quote from Einstein means: Always pay back compounding interest debt as soon as possible and when you see an opportunity to earn it, take it.
Share this article