Q: I was browsing the Web, looking for some good CD deals, and kept bumping into the same problem: The interest rate and the “APY” were always a little bit different. It got me wondering, why aren’t they the same? — D. Niestrom, Milwaukee
Banks calculate both percentages differently, and that can benefit you when you’re the recipient of interest — say as a CD investor. But if you’re an interest rate payer — say as a credit cardholder or mortgage borrower — the difference between the two can cost you more cash at the end of the year.
At the crux of the matter is compound interest. APR is the interest figured on an annual basis without factoring in compound interest.
On the other hand, APY is the interest rate on the same principle, but it includes compound interest — a significantly more accurate measure of interest.
That’s also why, when you’re reading those about those bank CD deals on the Web (and you should be bookmarking BankingMyWay’s CD Rate Search) banks tout the APY number over the APR number. You’ll earn more from the APY than you will on the APR.
That’s because the more frequently interest is calculated, the higher the yield will be. Let’s say you buy a one-year CD worth $1,000, and let’s say for the sake of the example it pays 5% interest twice a year. That means after six months you’ll generate your interest payment of $25 (or $1,000 x 5% x .5 years). But the $25 generates interest too, exactly $0.625 ($25 x 5% x .5 years). What you actually have here is a CD with an APR of 5% but an APY of 5.06%.
Conversely, it’s the same deal in reverse if you owe a bank interest. Let’s use the credit card analogy again. Banks rely on you to pay the APY when you pay your credit card (you do that by not paying your monthly balance and instead carrying the balance for a year). But if you paid your balance off every month, you’d be paying the APR, which is cheaper. As a result of compounding, you’ll pay more on your yearly credit card bill by allowing the APY to trigger in.