When you want to borrow money, perhaps for a car loan or home mortgage, you may research and compare rates among financial institutions to get the best deal. If so, you can be provided with interest rates and annual percentage rates (APRs) of current loan programs being offered by the institution.
If you want to save money, you might shop around for the best interest-bearing account. In that case, you’ll likely be given the interest rate for an account, along with the annual percentage yield (APY).
When given these numbers, you might think that there isn’t much of a difference, numerically speaking, between the interest rate and APY, or the interest rate and APR. Those differences, though, can be significant difference-makers when you want to maximize your money.
With a loan, the interest rate is a percentage charged by a lender for the use of money, with calculations based upon the loan’s principal. In the context of a savings account, a financial institution agrees to pay you a certain amount of interest based upon the money you have deposited in that institution.
Now, here’s more about how APRs and APYs are calculated, and much more!
If you deposited money into an interest-bearing account, then you would earn an annual percentage yield on those dollars. The APY calculation takes into account the interest rate being offered, and then factors in any account fees and costs, as well as whether the financial institution offers simple interest or compounded interest—if the latter, then it also matters how often the financial institution compounds that interest—perhaps monthly or quarterly.
If the bank offers simple interest, then the interest is simply calculated on the principal balance. If, for example, you invested $10,000 at an interest rate of 1.5%, at the end of the year, you’d earn $150. Compound interest, meanwhile, is interest calculated on the principle, plus any accrued interest—so, when compound interest is paid, it includes interest paid on interest.
Switching gears, when you borrow money from an institution and are quoted an annual percentage rate, this figure factors in the interest rate charged, along with fees and costs, but compounded interest is not part of the APR calculation.
One of the key differences in how APY and APR are calculated, then, is that one takes compounded interest into account, while the other one doesn’t.
The APY Formula
Figuring what you could earn on, say, your savings or certificate of deposit using simple interest is a reasonably straightforward calculation. The APY, meanwhile, provides a picture of what you would earn on a deposit-based, interest-earning account over a period of one year.
The actual formula for APY calculation is as follows: (1 + r/n)ⁿ – 1.
The “r” stands for the interest rate being paid, while the “n” represents the number of compounding periods within a year. If, for example, the interest rate paid was 1.5%, then that’s what you’d use for the “r.” If interest is compounded quarterly, then “n” would equal four.
So, the frequency of interest compounding can cause savings accounts with the same interest rates to have different APYs. For example, if two different banks offered a CD with the same interest rates, and one of them compounded annually, that institution would have a lower APY than the institution that compounded quarterly, or daily.
The good news is that if you want to compare savings rates from one financial institution to another, you don’t need to perform these in-depth calculations. Each institution would need to provide you with the APY and you could simply compare the figures. And, here’s the heart of it all: the higher the APY, then the more quickly the money you deposit can grow.
More About the APR vs. APY
Like the APY, calculating interest on a loan is fairly straightforward, with the APR providing a better snapshot of the true cost of the loan to you on an annual basis. It may take into account the points you paid, for example, to get a mortgage loan, and/or other fees and loan-related costs.
However, here’s where APR calculations differ from APY ones. The APR does not take into account how often interest is compounded on a loan. And, the more often it’s compounded, the more you’ll ultimately pay back on your loan.
So, besides comparing APR to APR from different institutions, to get a better understanding of what would be a better deal, also ask how often interest compounding takes place at each one.
Here’s how an APR might be calculated: Fees and interest paid over the loan’s life would be divided by the original loan amount. Take that answer and then divide it by the number of days in the term of the loan. Multiply that number by 365, and then by 100. Ta-dah! That’s your APR.
Although that’s the basic calculation, there’s one more factor to consider—how APR is calculated can differ by loan type. Credit cards, for example, can have different APRs for purchases vs. for cash advances.
Summing Up the Main Differences
In short, here’s the answer to this question: “What is APY vs. APR?”:
• APY calculates money paid to you on depository bank accounts such as savings and certificates of deposit. It factors in the interest rate, plus any fees, costs, and compounding interest frequency.
• APR calculates the money you would owe to pay back loans, such as car loans and house mortgages. It factors in the interest rate, plus any fees and costs, but it does not take into account the impact of compounding interest.
When your goal is to maximize your dollars, a good foundational step can be to get the most interest on your savings dollars.
Types of High Interest Accounts for Savings
When you’re saving money, perhaps to buy a house or go on an ocean cruise, there are several types of interest-bearing accounts that may be the right choice for your goals, with different APYs, fees, ready access to cash, and withdrawal terms.
Traditional checking and savings accounts don’t usually fit the bill when you’re looking for a high-yield account, although there are interest-bearing ones that might fit your needs quite well. Other choices can include money market accounts, certificates of deposits, and other forms of investments.
With a money market account, your money is typically invested in a reasonably safe way, perhaps in government securities. If you don’t need regular access to this money, this could be a good choice, as there are often limits on how many withdrawals you can make monthly.
You typically need at least $1,000 to open a money market account—for higher investments, incentives might be offered.
Certificates of deposits (CDs) are investments with fixed maturity dates, ranging from one month to 20 years—typically, you can’t easily withdraw money before that date. Some CDs are traded on the market as securities. Others are offered by banks, and aren’t securities. Interest rates tend to be higher on longer-termed CDs than ones with shorter terms.
Some CDs require a minimum deposit, while others don’t. Some CDs don’t charge penalties for early withdrawals, but many do, so read the fine print. A penalty can put a real dent in any APY earned.
If you want easy access to your CD dollars, you might seek out one with fewer withdrawal restrictions, or invest in CDs at regular intervals, helping to ensure that one will mature when you need funds.
High Interest Checking Accounts
These are accounts designed to give you the flexibility of a traditional checking account, but with high-interest returns. Rates vary, but are typically much higher than savings accounts. Many of these accounts, unfortunately, come with fine print, perhaps limitations on monthly debit card usage, or on minimum balances required, or mandated bill-pay automation.
What you really want to look for in the fine print, though, is whether or not there’s a balance cap on your interest earnings. This would basically limit how much money you can earn at the high interest rate. For example, perhaps a bank would pay 3% on checking accounts, but you’d only earn that interest on the first $2,000.
What SoFi Money Offers
If you don’t want your interest-earning potential to come with a ceiling, you might want to look at SoFi Money®, a cash management account where you can spend, save, and earn all in one place. We work hard to give you high interest and charge zero account fees. With that in mind, our interest rate and fee structure is subject to change at any time.
You’ll have the ability to write and deposit checks and you can use a debit card, send and receive money, and use ATMs, with the added benefit of earning interest.
SoFi Money is a cash management account, which is a brokerage product, offered by SoFi Securities LLC, member FINRA / SIPC . Neither SoFi nor its affiliates is a bank.
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