Comparing APR and APY to determine your mortgage rates can be daunting. The two acronyms are virtually identical. However, it’s simple to explain the difference and with a simple mnemonic you’ll always be able to keep the two straight.
What is APR? APR stands for “Annual Percentage Rate.” This number refers to the percentage of interest charged on a loan. For instance, if you have a $200,000 mortgage at a 6% APR, you’ll pay about (200,000 * .06) $12,000 in interest. This interest that you pay does not reduce the principal – the amount of the loan.
It’s important to remember that APR is a periodic rate, meaning that it is associated with a time period. The period for the interest rate must be specified. Usually this is daily, monthly, quarterly or annually. Shorter time periods lead to a higher overall payment for the borrower (see below). You will see APR rates associated with mortgages and other types of loans, including student loans, car loans and credit cards. What is APY? APY stands for “Annual Percentage Yield.” This number is calculated based on the APR, but incorporating the compounding of interest. APY is almost always slightly higher than APR (except on balances that compound interest annually).
Compound interest is the effect of an incremental increase in the principal. For example, if your mortgage interest is compounded monthly, you owe a little more every month. If you don’t pay down the balance, next month’s total is calculated on the principal plus the previous month’s interest. Compound interest is powerful – Alfred Einstein once referred to compound interest as the most powerful force in the universe. It’s important to put this force to work for you in your investments – and not to allow it to work against you with high-interest loans.
How to remember the difference between APR and APY
Some remember the difference between the two by remembering, “Rates are for debts, yields are for investments.” One economics professor teaches his students to recite: “APR, arrrrrr, I have to pay that.” APY, he says, stands for, “A profit, yes!” This little mnemonic should help you remember the difference between APR and APY.
How to calculate APY from APR
Calculating APY is simple. The easiest way is to use a compound interest calculator which will help you to calculate the APY based on the APR and the periodicity of the rate. Generally speaking, APR is all you have to consider when taking out a loan. But APY is the key figure used to calculate interest on investments.