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Why the Difference Between APR and APY Matters to Investors

Coryanne Hicks

The difference between APR and APY may be one small letter, but it's one giant leap in potential cost or return to investors. Both APR, the annual percentage rate, and APY, the annual percentage yield, appear on investments and financial products like credit cards, loans and CDs, but they are not interchangeable.

Knowing the difference between APR and APY is key to minimizing the interest paid or maximizing the interest you earn on your investments, says Andrew Crowell, vice chairman of D.A. Davidson & Co. Wealth Management in Los Angeles.

APR vs APY. APR is sometimes referred to as the stated interest rate. It's the annual interest rate on a product without taking into account any compounding that occurs throughout that year. APY, on the other hand, does account for compounding.

To illustrate the difference compounding can make, consider the example of two similar investments: Investment A pays 10 percent annual interest once per year; Investment B pays 5 percent twice a year for a total 10 percent annual interest. The APR on both of these investments is 10 percent, but not their APY.

What is APY? Compounding occurs when your interest earns interest. If you put $1,000 in Investment A, by the end of one year you'll have $1,100.

Put $1,000 in Investment B, however, and after the first six months you'll have $1,050. This means in the second half of the year, you'll earn interest on $1,050 instead of $1,000 so that by the end of the year, you'll have $1,102.50.

Compounding may seem minimal at first, but its power only grows with time. In 30 years, that $1,000 in Investment B will grow to $18,679.19 with semiannual compounding. Meanwhile, Investment A would be worth only $17,449.40 in 30 years.

The more frequent the rate of compounding, the faster your investment grows. If your 10 percent annual interest was paid in daily installments instead of semiannual, it'd be worth $20,077.29 in 30 years -- over $2,600 more than annual compounding.

Likewise, the difference between the APR and APY on an investment only grows the faster the rate of compounding. The APY on the 10 percent investment compounded semiannually would be 10.25 percent. When compounded daily, the APY becomes 10.47 percent. And yet the APR on both of these investments is still 10 percent.

Should I use APR or APY? You can use APY to compare two investments with different rates of compounding.

For instance, it may be hard to decide between a product paying 10 percent semiannually or one paying 10.2 percent annually. If you look only at APR, the latter seems better; 10.2 percent is higher than 10 percent, after all. But when you take compounding into account, the story is a little different.

To calculate APY you can use the formula: APY = (1 + r/n)^n - 1 where r is the stated annual interest rate and n is the number of times interest is compounded during the year.

An investment paying 10 percent compounded semiannually would have an APY of (1 + .1/2)^2 - 1, or 10.25 percent. As an investor, you'd do better to take 10 percent compounded semiannually.

Lenders use APR; borrowers use APY. APY will never be less than APR. If interest compounds annually, APY will equal APR, but any time interest is compounded more than once per year, the APY will be greater than the APR.

Since APY is typically higher, borrowers have an incentive to quote APY, Crowell says. For this reason, you'll often see APY on savings accounts, CDs, Treasurys and corporate or municipal bonds.

Lenders like credit card companies or banks offering you loans, on the other hand, prefer to use APR to understate the interest you'll have to pay.

APR accounts for fees. "There's one more significant wrinkle which must be considered in comparing APR and APY," Crowell says. "APR also factors in fees and loan costs, whereas APY does not."

So if you're borrowing funds and will be paying interest, APR is still an important consideration. Just make sure you also inquire how often that interest will be compounded.

[See: 7 Investing Lessons Dad Forgot to Teach You.]

Ultimately, the moral of this story is to know which rate you're being quoted. Then you can make the wisest choice for your circumstances, Crowell says.

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