Financial terminology can be perplexing at times. It needs a deeper level of understanding and study to master the financial dictionary. But in present times, where inflation is at all times high and the cost of living is touching the sky, knowing the basics of finances have become a must. Having a sound understanding of these financial jargons can help you make sound decisions and prevent you from losses. APR and APY are two key terms that everyone must know. Both APR and APY are related to interest but in different ways.
What is the difference between APR and APY?
In order to figure out the distinctions between these two terminologies, you must understand their in-depth meaning.
What is APY?
APY stands for annual percentage yield. It is the amount of money deposited into a bank account for more than a year and earns interest. However, APY considers compound interest rather than simple interest.
Simple interest only pays interest on the principal deposit. In contrast, compounding allows you to earn interest on the principal amount and interest earned over time. In order to earn a higher APY, invest in fixed deposits or corporate deposits rather than savings bank accounts.
How does APY work?
It is simple to calculate your APY. You only need to be aware of the interest rate and apply the following mathematical formula.
APY= (1 + R/N) ^N– 1
Where,
R = Rate of interest
N = number of years
Note: If compounding is done monthly or quarterly, you must adjust 'N' accordingly. Let's take an illustration to understand APY better.
Assume you have kept Rs 1,00,000 in your savings bank account. Your account earns 5% per year in interest. If you leave your money unused for 5 years, the APY will make it worth Rs 1,27,628. Here is how:
| Year | Opening Balance | Interest Earned | Closing Balance |
| 1st Year | Rs 1,00,000 | Rs 5,000 | Rs 1,05,000 |
| 2nd Year | Rs 1,05,000 | Rs 5,250 | Rs 1,10,250 |
| 3rd Year | Rs 1,10,250 | Rs 5,512.50 | Rs 1,15,762.50 |
| 4th Year | Rs 1,15,762.50 | Rs 5,788 | Rs 1,21,550.50 |
| 5th Year | Rs 1,21,550.50 | Rs 6,077.50 | Rs 1,27,628 |
Is APY variable?
The APY can be either fixed or variable. In case the APY is linked to a savings account, it is fixed. However, it may be variable if it is for corporate or fixed deposits. If your variable rate is linked to the benchmark rate, your interest income will rise with the base rate.
In contrast, if the interest rate falls due to any condition, your earnings from interest will be reduced.
What is APR?
The term APR stands for annual percentage rate. It, like APY, is linked to interest rates. However, it is related to loan interest payments. APR is essentially the amount you pay in addition to principal debt repayment.
It includes the interest rate and any other fees associated with your loan. For example, if you miss an EMI payment, the lender will charge you a penalty, which will raise the APR or borrowing costs. When applying for any kind of loan and researching lenders, you must consider APR rather than the interest rate.
Also Read: What are Annual Interest Rate (AIR) and Annual Percentage Rate (APR) How it is used How does APR work?
You can determine APR by using the following mathematical formula.
APR = {((Fees + Interest) ÷ Principal) ÷ n) × 365}
Where
'n' means the total number of days in the loan term
What are the components of APR?
As previously said, APR includes the interest rate charged to your profile. It further comprises of the following charges:
-
Processing fees
When you apply for a loan and the lender proceeds with your application, they incur administrative costs. And to cover that, a processing fee of around 0.5% to 2.50% is charged on the loan amount. The processing fee is typically non-refundable. Thus, comparing this charge to those of other lenders is advised.
-
Rescheduling charge
If you are in a financial bind and find debt repayment difficult, you may want to request that your lender extend your repayment period. This is referred to as rescheduling. And it comes at a cost that raises the APR.
-
Foreclosure fee
This fee applies if you want to pay off your debt before the due date. Foreclosure charges increase the APY, but if you pay close attention, you will notice that you are saving a lot of money on interest due to early loan closure.
-
Document verification charge
This fee is typically applied to secured financings, such as a loan against property. In a mortgage loan, the lender verifies the property documents from the relevant authorities and determines the market value. Verification charges cover the costs they incur in performing such activities.
To conclude
Although both APR and APY are related to interest, they are not the same. When you apply for a loan, APR comes into play. It includes interest rates as well as other fixed or situational charges. On the other hand, APY is a term used in an investment where interest income is compounded.
