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 how often interest is applied. Here's a very rough and simplified example. Let's say that an account in which 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. Each time, the interest was calculated 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 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.
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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