It’s important to understand the difference between annual percentage rate (APR) and annual percentage yield (APY) because if you don’t, you could end up paying more money on a loan than you ever anticipated. And, if your loan is a mortgage spanning 30 years or so, the increased amount of money that you will have to pay out can be huge.
How Big is the Difference Between APR and APY?
APR and APY Calculation Example
The difference between APR and APY can be quite minimal and quite overbearing. It all depends on the term of the loan and the amount you’re paying back. If the loan is for 2 months, a .12% difference is probably nominal. However, over 30 years, it can be intimidating.
Let’s take a $500,000 mortgage as an example, 30 year term at 5.00%.
If you’re paying strictly on the 5% APR which does not “charge” you a compounded interest rate, then your monthly payment would be $2,684. Total amount paid over 30 years would be $966,279.
However, if you’re being charged on APY, you are being charged a compounded interest rate which means your interest rate is no longer set at 5%; rather, it is now 5.12%. Big deal you think. Well, your monthly payment is now $2,721, an increase of $37. Not too bad you think. Well, the total amount paid over 30 years now increases from $966,279 to $979,523, and increase of $13,244.
How Are APR and APY Calculated?
Calculating Annual Percentage Rate (APR)
APR is a rather simple and familiar calculation.
APR = the periodic rate multiplied by the number of periods in a year. The periodic rate is typically the interest rate charged per month and it is either given to you or you can calculate it if you have the APR.
The periodic rate = (APR) / 12 months.
.42% = 5% / 12
APR = (periodic rate) x (# periods in a year)
5% = .42% x 12
Calculating Annual Percentage Yield (APY)
APY is not a familiar calculation but it’s important. Remember, APY deals with compounded interest which really means that principal AND interest are making more interest. It’s good if you are making money this way. You really don’t want to be paying money out this way.
APY = (1 + periodic rate)^ # periods – 1
The “^” in the equation is the exponential character
APY = (1 + .42%)^12 – 1 = 5.12%
APY = (1 + .0042)^12 – 1 = 5.12%