APR Vs. APY: What’s The Difference And How Do They Affect Your Mortgage?
Victoria Araj5-minute read
December 20, 2021
It can be easy to confuse APR (annual percentage rate) and APY (annual percentage yield). They sound similar and both involve interest. But be careful; they aren’t interchangeable. Knowing the difference can help you manage your money and make you a wiser borrower. With that in mind, here are some of the key differences between APR and APY.
What Is The Difference Between APR And APY?
Both APR and APY are used as measurements of interest, but APR focuses on the amount of interest that the borrower has to pay while APY calculates the interest paid to a borrower. When assessing APR, the smaller the percentage, the lower the cost of borrowing money through a personal loan or mortgage. On the other hand, a higher APY means that you’ll earn more from that type of financial investment, such as a deposit account or certificate of deposit.
The Major Difference: Compound Interest
Compound interest is calculated on a loan or deposit using two factors: the principal balance and the accumulated interest from previous periods. So, compound interest is earned on top of existing interest.
Here is the formula to calculate how much you’ll make with compounding interest:
B = P × (1 + R/N)(N × T)
- B: This is the ending balance, including the future value of the investment or loan and interest.
- P: Initial principal or what dollar amount you originally invested or started with.
- R: Annual interest rate in decimal form for the investment or account you’re using.
- N: The number of times the interest on an investment or loan compounds in a year.
- T: The length of time you’ll have the investment or loan.
Let’s say you deposit $6,500 into a savings account. There is an annual interest rate of 3%, and it’s compounded monthly for 4 years. If we put those values into the formula, we get:
$6,500 × (1 + .03/12)(12 × 4)
After 4 years, you’d have accrued a total of $7,327.63 in your bank account.
How To Calculate APR and APY
APR and APY are important formulas to keep in mind when you’re shopping for loans. Knowing how APR and APY are calculated can help you determine which option will save you money over time.
If you want to check your possible mortgage payment, you can also use a mortgage calculator.
You’ll need to know the expected fees and interest on a possible loan to calculate the APR.
Once you have those two numbers, you can begin:
- First, take the fees and total interest you’ll need to pay over the course of the loan. Add them together.
- Divide the sum of those two numbers by the loan principal.
- Take step 2’s result and divide it by the loan term’s total days.
- Once you have step 3’s answer, multiply it by 365.
- Multiply step 4’s answer by 100 to convert the APR into a percentage.
[((Fees + Total interest / Loan Amount) / Loan Term’s Total Days) × 365 ] × 100 = APR
Here is an example calculation:
- $400 in interest + $60 worth of fees = $460
- $460 / a principal of $3,900 = 0.11794872
- 0.11794872 / a term of 200 days = 0.00058974
- 0.00058974 × 365 = 0.215
- 0.215 × 100 = APR of 21.5%
Knowing a loan’s APR can be helpful for certain borrowers. Since APR includes the high closing costs a mortgage can involve, it can paint a more accurate picture for those looking for an affordable loan. Taking both the APR and interest rate into account when reviewing financing options allows you to see past initial fees and rates and to look at the true costs of borrowing from a lender.
You can use this formula to find the APY for some types of investments and loans:
APY = (1 + r/n)n − 1
The “r” is your interest rate in decimal form. The “n” is equal to the number of times your interest compounds in a year. For example, let’s say you have an interest rate of 0.05%, and the investment compounds monthly.
APY = (1 + 0.0005/12)12 − 1
APY = 0.050011%
Since APY is applied in situations where your investment is growing, you’ll want to know how to calculate APY. It will help you figure out how much money you can earn over a period of years.
Converting APR And APY
You can already find the APY using the APR value as we saw with its formula where “r” was the interest rate. You just input the APR into the formula’s r-value.
So, the calculation is:
APY = (1 + APR/n)n − 1
You can also use the APY to find the loan’s periodic rate, giving you the APR.
The equivalent formula is:
APR = n × (1 + APY)1/n − n
APR Vs. APY For Your Mortgage
Knowing how to use and calculate APR and APY can be helpful for future home buyers. The two values can give you insight into a mortgage’s true cost. APR can show you how much a loan might run, including fees like closing costs. In comparison, APY can give you a more accurate measure of the loan’s annual cost since it includes how often the loan is compounded. So, knowing both the APR and APY of your possible loan can help you get the best interest rate by making you a more informed borrower.
APR Vs. APY: Which Is Better?
Typically, APY is involved in situations where you earn money through interest on investments. In contrast, APR is used by your lenders for scenarios where you pay interest. So, you’ll typically find them applied in different settings. APR is useful when creditors use various fees, whereas APY can help with comparing compounded loans.
When APR Is Better
APR is a simpler formula than APY since it doesn’t include compound payments. However, there is an exception with mortgages. Their high closing costs are accounted for in APR, so it will give you a more accurate answer.
There are other situations when you may see APR applied, and most of them involve credit, like car loans and credit cards. Certain lending institutions like to use APR as a promotional offer to persuade borrowers. You might have a 0% APR period at the start, but there will be a high-interest fee for any remaining balance once it’s over. Financial institutions, like credit unions, banks or credit card companies can also decide what fees to include in the APR.
It’s best to get a breakdown of what your APR includes. That way, you can accurately compare it to other options. Generally, the larger the difference between the APR and interest rate, the greater the loan expense.
Keep in mind that your credit score can also influence your APR. The lower the score, the higher the APR will be on your loan.
When APY Is Better
APY is most useful when compound interest is involved since it takes that value into account. So, you’ll generally see it when investments come into play.
Some institutions like banks usually use APY for financial products. This can include high yield savings accounts, IRA CDs or money market accounts. The high APY rate can look better to customers and draw them in. However, you want to make sure that you know exactly how the institution is getting that rate so you can choose wisely.
Find out how often the money is compounded. The more frequently interest is added to the balance, the more money you’ll be making.
The Bottom Line: Make Informed Mortgage Choices
You want to ensure your interests are protected when you look for the right mortgage. The best method is to inform yourself. When you know how APR, APY and the true cost of interest data works, you can search for the best option on your terms. If you’re ready to see your loan options, apply for a mortgage or refinance online.
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