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APR vs APY: Simple Explanation and Comparison

APR vs APY: Simple Explanation and Comparison

Annual Percentage Rate (APR) simple explanation

An Annual Percentage Rate (APR) is the annual rate charged for a loan or earned by an investment, expressed as a percentage representing the actual annual cost of funds over the life of a loan. This includes any additional fees or costs associated with the transaction but does not include capitalization. Because loans or credit agreements can vary in terms of interest rates, transaction fees, late fees, and other factors, a standardized calculation such as APR provides borrowers with a net figure that they can easily compare to rates charged by other lenders.

So, what is an interest rate, you might ask?

An interest rate, or nominal interest rate, refers only to the interest on a loan and does not take into account other expenses. In contrast, APR is the combination of the nominal interest rate and any other costs or fees involved in obtaining the loan. As a result, an APR tends to be higher than the nominal interest rate of a loan.

For example, if you consider a US$200,000 mortgage with a 6% interest rate, your annual interest would be US$12,000 or a monthly payment of US$1,000. Let’s say that your home purchase also requires closing costs, mortgage insurance, and US$5,000 in origination fees. To determine the APR of your mortgage, these fees are added to the original loan amount to create a new amount of US$205,000. The 6% interest rate is then used to calculate a new annual payment of US$12,300. Divide the annual payment of US$12,300 by the original loan amount of US$200,000 to get an APR of 6.15%.

APY vs. APR: What’s the difference?

An APR only takes into account simple interest. In contrast, the annual percentage yield (APY), also known as the effective annual rate (EAR), takes into account compound interest. As a result, an APY tends to be greater than an APR on the same loan. The higher the interest rate and, to a lesser extent, the lower the compounding periods, the greater the difference between APR and APY.

Imagine that the APR on a loan is 12% and the loan is compounded once a month. If a person has borrowed US$10,000, his interest for one month is 1% of his balance or US$100. This effectively increases his balance to US$10,100. The next month, 1% interest is charged on that amount, and the interest payment is US$101, slightly higher than the previous month. If you carry this balance for the year, your effective interest rate becomes 12.68%. APY includes these small changes in interest charges due to compounding, unlike APRs.

Or, let's say you are comparing an investment that pays 5% per year with an investment that pays 5% per month. For the first, the APY is equal to 5%, identical to the APR. But for the second, the APY is 5.5%, reflecting the monthly compounding.

Since a different APR and APY can be used to represent the same interest rate, it stands to reason that lenders and borrowers will focus on the more flattering number.

A bank will advertise the APY of a savings account in a large policy and its corresponding APR in a smaller one since the former has a superficially larger number. The opposite occurs when the bank acts as a lender and tries to convince its borrowers that the rate is low. An excellent resource for comparing APR and APY rates on a mortgage is a mortgage calculator.

When applying this rule to the cryptos and DeFi market, products with a higher APY may not generate greater interest than those with a lower APR. When comparing products, such as savings and staking, make sure to consider the periods of staking. If they both have the same APR but one compounds monthly and the other daily, then the one that compounds daily may yield you more cryptocurrency interest. So, APR or APY? The key is to always double-check and convert to the rate you preferred when estimating the interest.

Disclaimer: This article is for educational purposes only and is not intended as investment advice. Qualified professionals should be consulted prior to making financial decisions.

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