APR Vs. APY: What’s The Difference And How Do They Affect Your Mortgage?

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.

Annual percentage rate is essentially the annual cost of borrowing money. It describes the yearly interest that you’ll pay for borrowing money, be it via credit card, mortgage, auto loan or another form of credit. In addition to interest rate, APR can also include additional costs, like annual fees. The lower the APR on your loan, the less you’ll pay in interest.

Sometimes called the effective annual rate (EAR), the annual percentage yield (APY) describes the amount of money your savings or other investments can earn annually. A higher APY means that you’ll have a higher rate of return on your investment.

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 amount of interest earned when saving. As mentioned previously, 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.

One major difference between APY and APR is that APY takes compound interest into account. 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 (Balance): This is the ending balance, including the future value of the investment or loan and interest.
• P (Principal): Initial principal or what dollar amount you originally invested or started with.
• R (Rate): Annual interest rate in decimal form for the investment or account you’re using.
• N (Number): The number of times the interest on an investment or loan compounds in a year.
• T (Time): The length of time you’ll have the investment or loan.

Compound Interest Example

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 + 0.03/12)^{(12 × 4)}

Let’s walk through the formula.

1. Rate divided by number of times compounding: 0.03 / 12 = .0025
2. Add 1 to (R/N): 1 + 0.0025 = 1.0025
3. Calculate the exponent: 1.0025^{(12 × 4)} = 1.127328
4. Multiply that by your principal: $6,500 × 1.127328 = $7,327.63

After 4 years, you’d have accrued a total of $7,327.63 in your bank account.

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.

Calculating APR

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:

1. First, take the fees and total interest you’ll need to pay over the course of the loan. Add them together.
2. Divide the sum of those two numbers by the loan principal.
3. Take step 2’s result and divide it by the loan term’s total days.
4. Once you have step 3’s answer, multiply it by 365.
5. 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

This formula applies to personal loans.

APR Example

Here is an example calculation:

1. Add fees and interest together: $400 in interest + $60 worth of fees = $460
2. Divide the sum by the loan amount: $460 / a principal of $3,900 = 0.11794872
3. Divide the total by the loan term in days: 0.11794872 / a term of 200 days = 0.00058974
4. Multiple total by 365: 0.00058974 × 365 = 0.215
5. Multiple total by 100: 0.215 × 100 = APR of 21.5%

Knowing a loan’s APR can be helpful for certain borrowers. Since APR includes the 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.

Calculating APY

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. Here’s what that formula looks like:

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.

APY Example

Using the example numbers above, here’s how you’d calculate APY:

1. Divide the rate by the number of times interest is compounded: 0.0005 / 12 = 0.000042
2. Add 1 to the sum: 1 + 0.000042 = 1.000042
3. Calculate the exponent: 1.000042¹² = 1.0005
4. Subtract 1 from the total: 1.0005 − 1 = 0.05011%

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

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.

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 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.

APR and APY are both formulas used to measure interest, and they have important implications for home buyers. 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. You can also give us a call at (833) 326-6018.