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.
Based on the APR you might expect to only get charged $120 of interest by the end of the year. But in this example, the interest compounds monthly, meaning each month's interest is calculated based on the original balance and any interest that has accrued so far. So you'd actually get charged $126.83 by the end of the year, hence the 12.68% APY. Best bet: Compare loan offers based on APR. For instance, 15-year mortgage offers in the New York metropolitan area ( found here on BankingMyWay.com.) include a 4.888% APR from HSBC Banks USA ( HSBC) and a 5.075% APR from NBT Bank ( NBTB) . Meanwhile, it's also okay to compare deposit accounts using APY -- such as 12-month CD offers from Nara Bank ( NARA) with a 3.25% APY and Bank of America ( BAC) with a 2.0% APY in the same New York area. For interest rates on mortgages and CDs in your area, enter your ZIP code at BankingMyWay.com.