Quick overview
APR and APY both express annual percentages, but they answer different questions. APR answers “How much will borrowing cost me over a year (including required fees)?” APY answers “How much will my savings grow in a year after compounding?” The federal Truth in Lending Act requires lenders to disclose APR so consumers can compare loan offers (see Consumer Financial Protection Bureau), while banks and credit unions advertise APY to show customers the effective return on deposit accounts (see FDIC consumer resources).
This distinction matters in everyday decisions: when evaluating mortgages, credit cards, or personal loans you should focus on APR; when choosing a savings account, money market, or certificate of deposit, compare APYs.
How APR works (and what it includes)
-
What APR represents: APR is meant to show the yearly cost of credit as a single percentage. For many consumer loans, APR combines the nominal interest rate plus certain mandatory fees (for example, origination fees on mortgages or personal loans) expressed over a one-year period to make comparison easier. Regulatory disclosures (TILA/Reg Z) dictate how APR must be calculated and presented to consumers (Consumer Financial Protection Bureau).
-
What APR usually does not include: APR typically does not capture variable costs after the loan closes (late fees, returned-payment fees) or optional add-ons. For credit cards, APR is often a periodic rate expressed annually; fees like annual fees can be disclosed separately and should be included in your effective cost analysis.
-
How compounding is treated: APR is a rate that does not reflect the effect of intra-year compounding for savings; for loans, APR’s intention is to show a standardized yearly cost rather than modeling daily interest accrual exactly. For exact cash-flow comparisons you may need the effective annual rate (EAR) or an amortization schedule.
How APY works (and why compounding matters)
-
What APY represents: APY equals the actual percentage growth of a deposit over one year, factoring in how often interest is compounded. If an account compounds interest monthly, daily, or continuously, APY captures those effects so you can fairly compare accounts.
-
The APY formula (conceptual): APY = (1 + r/n)^n − 1, where r is the nominal interest rate and n is the number of compounding periods per year. For banks that quote APY directly, you don’t have to calculate it yourself—APY already reflects compounding frequency.
-
Why it matters: Compounding frequency can make a small but measurable difference over time. For short horizons the difference is small; for multi-year horizons compounding can noticeably increase total returns.
Practical examples (how to compare offers)
Example 1 — Comparing two savings accounts
- Account A: Advertised 1.95% APY (compounded daily) — actual balance growth is shown by APY, so $10,000 becomes about $10,195 in one year.
- Account B: Advertised 1.90% APY (compounded monthly) — slightly less than Account A; $10,000 becomes about $10,190 in one year.
Because APY already includes compounding effects, you can compare the two APYs directly. A higher APY wins for a like-for-like account.
Example 2 — Comparing two loans
- Loan A: 3.5% interest rate but $800 origination fee on a $200,000 mortgage.
- Loan B: 3.75% interest rate with no origination fee.
Even though Loan A has a lower stated interest rate, the origination fee increases the loan’s APR. APR converts the fee into an annualized percentage so you can compare the effective yearly cost. Use the lender’s APR disclosure (required by law) to compare these two loans. For precise lifetime cost comparisons, run an amortization schedule that includes upfront fees and closing costs.
Converting APR and APY: when you might need it
Sometimes you’ll see a nominal rate (interest rate) and want to know the equivalent APY or effective annual rate. Use APY for deposit comparisons. To convert a nominal rate to APY if you know the compounding frequency, apply APY = (1 + r/n)^n − 1.
For loans, if you need the effective cost including compounding you may calculate the effective annual rate (EAR). For short-term or irregular cash flows, use an amortization table or an online calculator to avoid mistakes.
Decision rules: which metric to prioritize
-
If borrowing (mortgage, auto loan, personal loan, credit card): focus on APR. Check whether the APR includes origination fees and note any recurring fees. Also request the loan’s full repayment schedule or look at the total finance charges on the disclosure.
-
If saving or investing (savings accounts, CDs, money-market funds): focus on APY. Compare APYs across institutions and confirm compounding frequency. For investment products that are market based (mutual funds, brokerage accounts), advertised “annualized returns” are different from APY and often reflect historical or projected returns.
-
For credit cards: compare APRs for purchases and cash advances, but also factor in annual fees, balance-transfer fees, and penalty fees. A low promotional APR may be attractive, but the total cost depends on how you plan to use the card.
-
For short-term choices: compare total dollar costs or returns for your holding period. A slightly higher APY may not matter if you need the cash in a few weeks; similarly a small APR difference may be less important than flexible repayment terms.
Common mistakes and red flags to watch for
-
Only comparing nominal rates: a low nominal rate with big fees can be more expensive than a slightly higher-rate loan with no fees. Always compare APRs for credit products and APYs for deposit accounts.
-
Forgetting compounding: on savings, two accounts with the same nominal rate but different compounding can produce different APYs.
-
Ignoring the fine print: promotional 0% APR offers, deferred-interest contracts, or teaser rates often have conditions that can change costs later. Read disclosures carefully.
-
Treating investment returns like APY: many investments report past performance or projected returns, which are not equivalent to bank-style APY—understand the difference.
Practical steps to compare offers (checklist)
- Get the APR and the itemized fee list for any loan; ask lenders to show the APR disclosure required by law (Truth in Lending/Reg Z).
- If you’re comparing deposit accounts, compare APYs and confirm compounding frequency and minimum balance requirements.
- Use an amortization calculator or ask for a total-payments table for loans to compare lifetime costs, not just monthly payments.
- For credit cards, simulate scenarios: one where you carry a balance, one where you pay in full—fees and APRs affect each scenario differently.
- If unsure, consult a fee spreadsheet—convert fees to an annualized cost to compare apples to apples.
In my practice: common client situations
-
First-time homebuyers often fixate on the nominal interest rate. I always ask for the APR disclosure and a full estimate of closing costs; in many cases the “lower rate” loan proved costlier once fees were added.
-
Savers switching banks sometimes chase a slightly higher nominal rate without checking APY; I recommend confirming APY and compounding and ensuring the bank is FDIC-insured for deposit protection.
-
Small-business owners comparing short-term financing should look beyond APR to repayment schedule alignment with cash flow. A slightly higher APR with flexible prepayment terms may be preferable to a lower APR with punitive penalties.
Tools and resources
- Consumer Financial Protection Bureau (CFPB) — guides on APR disclosures and your rights under the Truth in Lending Act.
- FDIC consumer pages — explanations of APY and how banks advertise deposit yields.
- Online amortization and APY calculators — use these to translate rates and fees into dollar costs and returns.
For more depth on how fees affect APR calculations see our article on “The Role of Origination Fees in APR Comparisons” and for converting APR to effective annual rates read “Understanding Effective Annual Rate (EAR) vs APR.”
- Internal link: APR vs. APY — https://finhelp.io/glossary/apr-vs-apy/
- Internal link: APR (Annual Percentage Rate) — https://finhelp.io/glossary/apr-annual-percentage-rate/
- Internal link: The Role of Origination Fees in APR Comparisons — https://finhelp.io/glossary/the-role-of-origination-fees-in-apr-comparisons/
Frequently asked questions
Q: Which should I use to compare mortgages?
A: Use APR to compare total borrowing cost, but also review the lender’s Good Faith Estimate or Closing Disclosure for full closing costs and the amortization schedule for monthly cash flows (CFPB).
Q: Is APY always better than a stated interest rate?
A: APY is the better comparison for deposit accounts because it already includes compounding. A higher APY yields more dollar interest over the same period.
Professional disclaimer
This content is educational and not personalized financial advice. For decisions that materially affect your finances—such as choosing a mortgage, taking on business debt, or building a long-term investment plan—consult a certified financial planner or qualified advisor who can review your full financial picture.
Authoritative sources and further reading
- Consumer Financial Protection Bureau — Truth in Lending/ APR disclosures (cfpb.gov).
- Federal Deposit Insurance Corporation — Consumer guidance on APY and interest (fdic.gov).
- Truth in Lending Act (Regulation Z) — requires lenders to disclose APR and finance charges.
