People are often confused about interest rates when they see terms such as APY (annual percentage yield) and APR (annual percentage rate). So, let's clear up the confusion.
You'll typically see one (APR) cited in relation to mortgage loans and the other (APY) in regard to interest-bearing accounts.
Here's the definition for APR from InvestorWords.com: "The yearly cost of a mortgage, including interest, mortgage insurance, and the origination fee (points), expressed as a percentage."
And here's APY's definition: "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, taking 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/applied just once a year, you'd earn $600 at the end of the year.
But most interest compounds more 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 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, showing what the effective rate is.
These concepts can be a bit tricky -- learn more in this scoop from the Chicago Fed and more from the New York Fed.
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