Both have formulas based on legislation. The Truth in Lending Act dictates how an APR is calculated, while the Truth in Savings Act describes how an APY is calculated. Based on which “act” gets to decide the definition, can you guess that APR has something to do with borrowing and APY has something to do with investing or your savings account? The government decided to get involved with the definitions and calculations to make it easier for consumers to comparison shop loans or investments. That’s why it’s so confusing.
One very important difference between the two is that APR doesn’t take compounding into consideration. APR just considers interest expense by taking the stated interest rate for a period and multiplying it by the number of periods in a year. If a credit card has a daily periodic rate of 0.060247 percent, for example, the APR is 0.060247 percent x 365 = 21.99 percent. Ouch!
But, APY does take compounding into consideration. It adds 1 to the periodic rate and raises that sum via exponents to the number of periods in a year. Then 1 is subtracted from the result to arrive at the APY. Calculating that credit card’s daily periodic rate of 0.060247 percent, the APY is: ((1 + 0.00060247)^365) – 1 = 24.587 percent. Big ouch, because this is what you’re actually paying.
I’m going to bet that you’re not really concerned about how these rates are calculated and you want to just know how to make a decision when you have one of these numbers staring you in the face. When you’re sitting in front of a loan officer, or the “finance guy” at the local car dealership, they will almost always quote you APR. Why? It’s a lot easier to get you to agree to a lower number. That’s why you should always arrange your financing before you go car shopping.
Conversely, when you’re dealing with an “investment guru,” he or she will almost always quote APY. Why? Same reasons, just in reverse. The investment guru wants your money and will try to pitch the investment in the best possible light.
One more key point: always know how many times per year the interest is calculated. This is known as the number of time periods. A daily rate will be vastly different than a monthly or quarterly rate. Always know what you’re spending and what you’re saving.
Making a wise decision when it comes time to part ways with your money is all about information and understanding how financial tools work. If you have that basic understanding, you’ve tilted the odds in your favor.
It’s about time, isn’t it?