The financial world has plenty of abbreviations and terms which sound confusing. If you aren’t aware of the lingo involved with personal finance, then your head may start spinning when you read your bank and credit card statements.
APR and APY are two of the most common acronyms used in the financial sector, and many people have no idea what the letters stand for, or what the terms mean. In this article, we’re going to break down everything you need to know about APR and APY.
- 1 APR Explained
- 2 The Mechanics of APR
- 3 Let’s look at an example of how to calculate APR on loans and credit cards.
- 4 Representative or Typical APR
- 5 What Constitutes a Good APR?
- 6 Avoiding APR
- 7 APY Explained
- 8 Why APY is the Benchmark for your Investment or Savings Account
- 9 Key Takeaways – The Difference Between APR and APY
APR is an acronym for “Annual Percentage Rate.” This term describes the annual interest you pay on any loans from banks or lenders. Legislation requires that all financial lenders explain the terms and conditions of APR on any products they sell to consumers. By displaying the APR, lenders allow you to compare rates between lenders, ensuring that you get the best deal when loaning money.
Visit the website of any financial institution that facilitates lending, and most of them will have an APR calculator on the site. This calculator allows you to find out the total cost of the credit issued to you, as well as how much interest you pay on the account, and your monthly installments. Most calculators let you play around with the monthly amount, showing how much you can save if you increase your payment.
The Mechanics of APR
All lenders calculate APR based on industry regulations set by the financial authorities and financial services board. This regulation ensures that financial institutions do not engage in predatory financing, where they take advantage of people looking to borrow money.
The regulations stipulate how lenders charge interest to your account, and any other fees involved in providing credit to consumers. The laws make it easy for anyone to calculate the APR on their credit facilities, and compare them to other products offered in the market.
Let’s look at an example of how to calculate APR on loans and credit cards.
If you sign a contract with a bank for a personal loan facility of $1,000, with an APR of 12-percent, the interest on the account costs you $120. This figure assumes that you pay nothing back on the principle you owe; in other words, you make no payments on the loan. In reality, you’ll be making monthly payments on the outstanding debt. Therefore, as you reduce the outstanding principal, you’ll pay less interest.
Lenders add APR to the outstanding debt every month. To calculate your monthly interest costs, divide the APR by 12. Therefore, the monthly APR owed on the principal is 1-percent, or $10. It’s important to note that the amount of interest you pay on the outstanding amount depends on the length of your repayment schedule. Therefore, if you were to take a 2-year loan facility, the monthly repayment would be lower, but you’ll be paying more in interest.
Representative or Typical APR
We’ve discussed that APR is the interest rate you pay on any credit facilities with a lender. When you open a credit facility, you may notice that the lender advertises either typical or representative APR in the repayment terms and conditions.
Representative APR is what lenders use when advertising credit facilities, such as personal loans and credit cards. However, when it comes time to sign the contracts, the lender may change the APR. Lenders base your APR on a variety of factors, such as your credit score and history with the lender.
Therefore, you may end up paying more for your credit than the advertised rate. While you may think this is a predatory lending strategy, it’s an industry-wide phenomenon that all lenders practice. If you have a credit score that’s in the 800s, then you can negotiate with your lender to secure an APR that’s lower than the 12-percent in our example.
Because you have a good credit score, the lender is likely to offer you a point or two off of the representative APR rate. However, if you have a weak credit score in the 600s, then the lender may choose to bump up your APR to 17-percent. This strategy incentivizes you only to use the facility if necessary. Lenders offer a higher APR to people with weak credit scores to reduce their risk in the deal.
The representative APR advertised by the lender “represents” the typical rate charges to 51-percent of consumers that take on a nominated credit facility. This term means that the other 49-percent will be either paying less or more than the representative APR figure in the advert.
It’s for this reason that its vital you check your credit score and credit report before applying for any credit facility. When the lender calculates your APR, they issue a “hard inquiry” on your credit report, resulting in a temporary drop in your credit score.
Many people make the mistake of filling out credit applications with numerous companies. However, the consumer does not realize that every time the lender pulls up your credit report, it results in more points deducted from your credit score, and a higher APR on the facility.
Instead of applying for five or six different facilities, find out your credit score with the credit bureaus. Visit the lender and ask them what an APR would be for your credit score and lending profile, without telling them to check on your credit report.
While no lender will commit to an APR without checking your credit report first, they can provide you with a ballpark figure for your research. Using this strategy helps you to preserve your credit score by reducing hard inquiries on your credit report. After finding a lender that offers the lowest APR based on your research, start your application process.
What Constitutes a Good APR?
As previously mentioned, the APR you receive on credit facilities depends mainly on the health of your credit score and your history of dealing with the lender. If you see a lender advertising “0-percent introductory offers,” then you should not take this as the APR they will offer you on the facility.
Lenders use this advertising strategy to convince consumers to apply for credit. The 0-percent introductory offer means that you only pay 0-percent on the facility for a specified period, usually between five to 10-billing cycles. After the introductory period ends, you’ll have to pay the specified APR set by the lender per your credit score.
Most lenders offer a 0-percent introductory rate and fleece their clients with a higher APR after the introductory period expires. The average APR after the introductory period ends will typically be between 18 to 20-percent. As a guideline, any credit facility with an APR lower than 18-percent, is “cheap,” while the 20-percent mark is on the high side.
Consumers with poor credit scores may receive an APR of anywhere between 24 to 50-percent. If you speak to your financial advisor, then they are likely to tell you to avoid taking on any credit facility with an APR higher than 24-percent. In these cases, the cost of the debt is not worth the convenience of the credit, and it may result in your paying far more than you can afford for your monthly repayment on the facility.
Some lenders provide consumers with “secured credit cards” if they have no credit score or bad credit. However, these cards typically come with outrageous APRs exceeding 24-percent, as well as high annual account fees, which you need to pay upfront.
While lenders charge high APR on credit cards, there is a way to avoid paying any interest on your facility. Most lenders offer a moratorium period if you pay off your outstanding balance in less than 55-days. This period differs from lender to lender, and not all of them will offer a moratorium period on interest.
However, if you are a responsible lender, and you pay off your credit card in full at the end of every month, then you will never have to pay any interest on your outstanding balance. This interest-free moratorium allows you to benefit from your spending and payment habits by improving your credit score.
Most credit card companies also offer incentives and rewards for paying off your balance early. Frequent flyer miles and other rewards programs offer you cashback on a wide range of goods and services as a reward for using your credit responsibly.
Before you sign up for any credit facility, especially credit cards, inquire with the lender about the APR, interest moratorium, and rewards programs.
APY refers to an acronym for “Annual Percentage Yield.” APY is a useful tool for calculating the interest you earn on your money. Most lenders offer consumers an interest rate quote when opening a savings or investment facility with their institution. However, this figure is not an accurate measure of the potential returns on your funds.
APY offers a more comprehensive calculation on the annual interest because it takes into account the effect of compound interest on your funds over the year. APY accounts for the interest you earn on deposits, as well as interest earned on interest accrued through your investment. It’s for this reason that it’s better to choose an investment facility offering a higher APY.
When depositing funds into a CD, money market, or savings accounts, the financial institution will pay you interest on your money. The APY rate differs from lender to lender, as well as between financial products. Some institutions may also only offer APY interest on deposits over a certain specified amount, such as $2,000. Therefore, it pays to shop around for the best APY available before you allocate your funds to any investment.
Why APY is the Benchmark for your Investment or Savings Account
APY is the benchmark for selecting a savings or investment account because it uses compound interest to give you an accurate picture of what you can expect in terms of interest earns on your investment over the duration of a year.
Compound interest is one of the secrets of building wealth because it allows you to earn interest on the interest accrued in your investment. The compounding effect starts small, but if you park your money in an investment account for the long term, such as over 10 to 20-years, then you’ll reach a tipping point where the annual accrued interest goes exponential, dramatically increasing the amount of money you earn on your savings and investments.
For example; If you deposit $1,000 into a CD or savings account that offers a 5-percent annual interest rate, then you’ll earn an additional $50 over the year. At the end of the year, you have $1050 in your investment account. However, if the lender calculates and pays interest on your savings every month, which is often the case, then you’ll have $1,051.16 at the end of the year. In this example, you earn an APY of more than the quoted 5-percent rate.
While the extra $1.16 may not seem like much, you can imagine the difference it makes if you keep adding to your investment every month, and if you deposit more than the $1,000 in this example.
Key Takeaways – The Difference Between APR and APY
By now, you should have an idea of the difference between APR and APY. APR describes the amount of interest a lender charges you on a credit facility. The APR also varies from lender to lender, and between financial products.
APY describes the interest a financial institution pays you on any money you deposit in a financial vehicle, such as an investment or savings account. APY also differs between products and financial institutions, and you shouldn’t confuse it with the interest rate quote on offer.
APY allows you to benefit from the effects of compounding interest on your deposit, increasing your wealth. APR describes the amount of money the lender takes away from you for the privilege of loaning money.
When it comes to finding the best APR, always look for the lowest figure on offer from the lender, and ensure that they provide you with the typical APR, and not the representative APR.
When sourcing the best APY, look for the highest figure on offer from financial institutions, and don’t confuse it with the average quoted annual interest rate.