Savings 101: Understanding APR vs. APY

Interest rates play an important role when deciding where to borrow or invest your money. But interest rates often show up in two ways: an annual percentage rate (APR) and an annual percentage yield (APY). Not sure what means what? Here's the difference between the two and how they're typically used.

APY takes into account the compounding nature of interest while APR does not, so APRs tend to be lower than APYs for a given base interest rate. For this reason, banks generally list the APR for debt-related accounts such as credit cards and mortgages, whereas APY often appears next to interest-bearing accounts such as certificates of deposit (CDs) and money market accounts.

The base interest rate is essentially a simple interest rate for a specific period of time, such as a day or a month. If your credit card charged a base rate of 1% per month, it would list an APR of 12% (1% per month x 12 months). That same account, however, would carry an APY of 12.68% (calculated using a fairly complicated formula of (1 + base rate)# of periods - 1 ). Why the difference? Compounding interest.

Here's how that works: Starting with a balance of $1,000, the first month's interest would be $10, or 1% of $1,000. The second month's interest would be $10.10, or 1% of $1,010, since the interest is calculated on the original balance plus the first month's interest. The third month's interest would be $10.20, or 1% of $1,020.10, and so on. The same is true if you are calculating the interest charged on a loan or earned on an account.