People often get confused about interest rates, especially when they see terms such as APY (annual percentage yield) and APR (annual percentage rate). Let's clear up the confusion.
You'll typically see APR cited in relation to mortgage loans and APY in regard to interest-bearing accounts.
InvestorWords.com defines APR as "the yearly cost of a mortgage, including interest, mortgage insurance, and the origination fee (points), expressed as a percentage."
APY, meanwhile, is defined as "the effective annual return. The APY is calculated by taking one plus the periodic rate raised to the number of periods in a year. For example, a 1%-per-month rate would offer an APY of 12.68%."
The APY is informative for Fools, because it tells you what to expect from the interest rate, since it takes into account howoften interest is applied. Here's a very rough and simplified example. Let's say that an account where you keep $10,000 pays you 6% interest. If the interest is compounded or applied just once a year, you'd earn $600 at the end of the year.
But most interest compounds much more often than once a year. Typically, it's more like monthly, weekly, or daily. Let's imagine that your account compounds interest monthly. If so, at the end of the year you'll end up with more than $600. That's because when the first month's interest was added (perhaps it was something in the neighborhood of 0.5%), you immediately had more than $10,000 in your account after just one month. And more was added each month. So, each time the interest was calculated, it was on a slightly bigger principal. The more often interest is compounded, the more money you'll end up with -- although the difference isn't always enormous. If your APR is 6%, and your interest is added monthly, the amount you'll end up with in two years works out to be an APY of 6.17%.
Sometimes, you'll see APR used to reflect a basic interest rate on an interest-bearing account, with a corresponding APY listed to show the effective rate.
And by the way, if stuff like this makes your head hurt and you'd like an actual person (a financial pro, no less) to talk to about your tax concerns and your financial planning needs, look into our TMF Money Advisor. It's a valuable service that features customized independent advice from a variety of objective financial experts. You need to make sure you're saving enough, and well enough, to meet all of your needs. Money Advisor can help.
The Motley Fool has kicked off its 13th annual Foolanthropy campaign! Nominate your favorite charities on ourFoolanthropy discussion board through Nov. 1. For guidelines on what makes a charity Foolish, visitwww.foolanthropy.com.