On the surface, APR and APY seem like similar terms. But are they? Read on as we break down the meanings of these two rates. We also have an APR vs APY example as well as a free APR calculator and free APY calculator.
Both APR and APY measure interest rates. However, while APR refers to the interest charged on credit, APY indicates interest earned on savings.
APR and APY are critically important, not just in personal finances, but in business finance as well. APR determines the cost of borrowing. I.e., the amount of interest that your business will pay for a loan, credit line, or business credit card. APY, on the other hand, determines how much more money you can earn simply by saving.
Needless to say, both APR and APY can affect your business’s cash flow. Therefore, it’s essential that every entrepreneur understands their meanings and how they differ, especially now that small businesses are still cash-strapped because of the coronavirus pandemic.
More on APR
APR is short for annual percentage rate. It is the rate at which interest is charged on money that you have borrowed. The higher the APR, the more interest you will pay. And conversely, the lower the APR, the less interest you will pay.
APR is typically applied on all types of credit. In a business context, that would include loans, asset financing, credit cards, and lines of credit.
You may have noticed from the APR meaning above that the “A” stands for annual. That’s because APR is charged over a period of one year.
APR Example
Say, for example, that you buy business equipment on credit for $10,000 with a 20% APR. In addition to the $10,000 balance, you’ll also have to pay a $2,000 interest in 12 months. That amounts to $166.67 per month.
Calculated as: 20/100 x $10,000 = $2,000
$2,000/12 = $166.67
One thing to note is that while APR accounts for simple interest, lenders typically divide the total rate by 365 (or 360 in some cases) to find your daily rate. They then apply that daily rate to your daily balance to find the amount you owe each day.
Thus, in the example above, the lender would divide the 20% APR by 365 to find your daily periodic rate. That would be 0.0548%. That’s the rate to multiply by your daily balance.
So, on the first day of the loan (when the balance is $10,000) then your interest for that day would be $5.48.
Calculated as: 0.0548/100 x $10,000 = $5.48
If on a particular day – after paying off some of the loan – your remaining balance is $6,000, then the interest for that day would be $3.288.
Calculated as: 0.0548/100 x $6,000 = $3.288
Use this free APR calculator to find out how much you will pay for a loan with an APR.
What does the APR tell you?
APR tells you how much you will pay for borrowing money. In other words, it’s the cost of credit. As the Consumer Financial Protection Bureau (CFPB) explains,
“APR is a broader measure of the cost to you of borrowing money since it reflects not only the interest rate but also the fees that you have to pay to get the loan”.
When you look at APR vs interest rate, APR captures a more accurate picture as far as the cost of credit. Oftentimes it takes into account other costs like insurance, lender fees and closing costs.
Variable vs fixed APR
Your APR may either be variable or fixed. Variable APR fluctuates with changes in index interest rates. Fixed APR, on the other hand, stays the same over the course of the loan. It doesn’t change even when index interest rates change.
Since lenders are legally required to display the APR of a credit facility on your statement, you’ll often see the amount of debt you have at each rate. If it’s variable APR, then you’ll also know the rate applied at each point in time.
What is a good APR rate?
A good APR largely depends on the originator of the loan. Traditional banks tend to give lower rates of 2 to 13%, albeit with higher underwriting fees. SBA loans typically carry an APR of between 3.75 and 10.25% while affordable online lenders may charge anywhere between 7 and 25%.
Some lenders do charge significantly more than 25%; up to 200%, in fact. However, any APR that’s above 25% is not a suitable rate, especially for a small business. The cost of the loan might prove too high, particularly now that businesses don’t have enough cash for credit expenses thanks to the COVID-19 pandemic.
More on APY
APY is short for annual percentage yield. Also known as effective annual rate (EAR), this rate applies to money that you have saved. It’s, therefore, cash that you earn off your savings or deposit account.
Or to put it simply, it is money that a deposit accepting financial institution pays on your account for saving with them. APY may also be applied on money market accounts as well as certificates of deposit (CDs).
APY is a great way to earn more cash on finances that you’re not planning to use immediately. For example, you can open a savings account where you deposit your business profits. The profits will yield more from APY interest.
APR vs APY: what are the major differences?
Contrary to APR, APY uses compound interest. That means you don’t just earn interest on the amount you’ve deposited in the account. You also earn additional interest on the interest that accumulates.
Despite the “annual” in APY, banks don’t always compound APY interest on an annual basis. Some banks do it monthly, others quarterly, some bi-annually, and some may compound the interest on a daily basis. If a bank compounds your APY daily, then you stand to earn more than a bank that compounds it monthly, quarterly, bi-annually or annually.
Generally, the higher the frequency of compounding, the more you earn. Thus, daily compounding is better than monthly, which is better than quarter, which is also better than bi-annually. Annual compound interest yields the least amount of earnings.
Another difference between APR and APY is that while APR can be fixed or variable, APY is always variable. It changes with fluctuating market interest rates. Plus, it’s always significantly lower than APR. For instance, the average APR on conventional small business loans is currently between 3 and 7% for bank loans. APY, on the other hand, stands at 0.04%.
APY Example
APY is calculated using the formula:
APY = (1 + r/n)n – 1
r is the interest rate expressed as a decimal. Thus, 0.06% interest would be 0.0006
n is the number of times your cash compounds in a year
Now, let’s say that you deposit $1,000 in a savings account with 0.06% APY. Assume that the amount compounds annually, i.e., once a year. Plug the values to get:
APY = (1 + 0.0006/1)1 – 1
= 0.0006
Multiply the APY (which is 0.0006) with your capital (which is $1,000) to find out how much you’ll earn in that year.
Interest earned = 0.0006 x $1,000
= $0.6
If the bank compounds your APY on a monthly basis, then the n would be 12 instead of 1. In which case, your interest by the end of the year would be:
APY = (1 + 0.0006/12)12 – 1
= 0.00060017
Interest earned = 0.00060017 x $1,000
= $0.60017
Obviously, the interest earned is not that much. The upside, however, is that it increases significantly when you deposit a huge amount of money.
What does the APY tell you?
APY can tell you how much interest your savings stand to earn in a year. The more money you have in your account, the more interest it’s likely to earn. Similarly, the higher the APY applied on your account, the more the interest earned.
As far as APY vs interest rate, APY is usually more helpful when it comes to comparing deposit accounts. That’s because it is compounding, which means that it generally earns more interest compared to interest rate. That said, APY earnings strongly depend on the number of times that it compounds per year and the rate applied.
What is a good APY?
The national average APY is 0.06, which is historically low. However, you can get some of the best APY rates – as high as 0.5 – from online banks. Better yet, high-yield online savings accounts offer even better rates and are extremely safe for keeping your business savings.
Differences Between APR and APY: A Summary
Type of interest
Although APR and APY both measure interest, APR is for interest charged while APY measures interest earned.
Direction of funds
APR is interest applied on loans and credit, which means it’s interest that you pay out. It is, therefore, an expense. On the other hand, APY is interest applied on savings and investments. As such, it is an income.
Accounts affected
Typically, APR is associated with credit accounts. These are accounts that hold loans, credit lines, credit cards and other forms of credit. To the contrary, APY is associated with deposit accounts. These are typically savings and investment accounts.
Rate
APR usually carries a higher rate compared to APY. A good APR ranges from 3% all through 25%, depending on the type of lender. That said, it’s practically impossible to get an APY rate that’s even remotely close to 3%. The maximum you can get in these COVID-19 times is typically 0.45%.
Type of interest
While APY uses compounding interest, APR doesn’t. The latter uses simple interest that’s divided into a daily rate.
Fluctuation
Contrary to APR, which can either be fixed or variable, APY is almost always variable. As such, your APY rate will always change depending on market forces. APR, on its part, may or may not follow market forces.
What Is Better APR or APY?
In simple terms, APY is better because it’s the interest that you earn. In other words, you gain money when APY is applied to your account. APR, on the other hand, is interest that you pay. It’s, therefore, an expense.
APR is a necessary expense because at some point, all businesses need credit to maintain a healthy cash flow. That’s especially the case now that most businesses have been hit hard by the coronavirus pandemic.
