We have been receiving questions about interest rates with APY and APR. How are they factored in for loans and investments? How can one word make such a big difference?
Not sure what the difference is between APY and APR? Not to worry. Below we have defined each term and what you need to consider when deciding the best interest rates. We also explain how compound and simple interest can influence final balances.
APRs are the yearly interest COSTS to borrow money for a loan. The APR represents the interest amount that you need to pay back in addition to a loan balance. It is important to note that the interest rate can vary depending on what type of loan you are looking into. Loans typically involve simple interest.
APY is the yearly interest EARNINGS that you receive on an investment or savings account. Instead of owing interest on the principal amount, you receive interest. Moreover, the interest that you receive almost always factors in compounding.
So, what is compound and simple interest?
Simple interest is the lower calculated interest amount of the two. It’s determined by multiplying the principle amount by the interest rate, and by the time of the loan.
Compound interest is the higher calculated interest amount. Compound interest is the accumulation of interest on interest. It is calculated by multiplying your interest rate by each pay period balance like simple interest, but every sequential multiplication includes the previous interest balance calculated in.
For the above equations; P represents the principal balance, r represents the interest rate and n represents the number of times the interest is applied over the course of the year.
| Balance | Annual 10% interest amount | Balance | Bi-annual 5% interest amount | |
| Initial deposit | $5,000.00 | $5,000.00 | ||
| 6 month mark | X | X | $5,250.00 | + $250.00 |
| 1 year mark | $5,500.00 | + $500.00 | $5,512.50 | + $262.50 |
| 18 month mark | X | X | $5,788.12 | + $275.62 |
| 2 year mark | $6,050.00 | + $550.00 | $6,077.53 | + $289.40 |
TABLE: Compound interest comparison for of $5,000 investment at 10% for two years.
As you can see in the table above, the frequency of the compound interest influences the final return on investment (ROI). Although the total yearly interest rate is the same, the frequency of the compound interest influenced the total return. The 5% bi-annual compound interest rate resulted in an increase of $27.53 versus the annual 10% rate. You could expect an even higher ROI if you were able to have daily compounding.
When taking out a loan, you are going to get an APR. You will either experience simple or compound interest. Fees may also apply before you begin making payments. Although very rare, you do not want compound interest for a loan. You will end up paying more over time. Be sure to have your loan officer explain the total balance you anticipate paying. You have the legal right to understand your loan and the interest payments.
The best-case scenario is negotiating a low interest rate with simple interest. You want a standard interest rate that is not compounded because you will pay even more interest. Paying off loans quicker will also decrease the total amount of interest you will end up paying. So, if you can put a little more towards payments each month when you are able to, do it.
There are three factors to consider when tackling an investment.
Lastly, compare interest rates. By all means do your research. You may find that some financial institutions offer better rates than others. Investigate your options for both APRs and APYs.
When it comes to APY and APR, the difference is whether the interest is for a loan or an investment. The two types of calculated interests will either be simple or compound. We offer extremely competitive interest rates against the industry average. If you feel you have more questions or want to learn more about our offers, speak with one of our accountants to pick the best interest rate for you.