The core difference
APR (Annual Percentage Rate) is the simple interest rate for a year, plus certain fees. It doesn’t account for compounding—interest earning interest.
APY (Annual Percentage Yield) includes the effect of compounding. It shows what you actually earn (or pay) after interest compounds over the year.
APY is always equal to or higher than APR because compounding always adds to returns. The more frequently interest compounds, the larger the gap.
Why the distinction matters
Financial institutions aren’t required to show both numbers in all contexts. They typically show whichever number is more favorable to them:
Lenders show APR on loans and credit cards. A lower number looks better, so they show the one that ignores compounding. That 24% APR credit card actually costs you more than 24% annually because interest compounds monthly.
Banks show APY on savings accounts. A higher number looks better, so they show the one that includes compounding. That 5% APY high-yield savings account actually pays a 4.89% APR that compounds to reach 5%.
This selective presentation isn’t deceptive—it’s required by regulations in most cases. But understanding what you’re looking at prevents confusion.
The compounding math
Here’s how compounding creates the difference:
Simple interest (APR basis): $10,000 at 5% APR for one year = $500 in interest.
Compound interest (APY basis): $10,000 at 5% APR compounding monthly:
- Month 1: $10,000 × (5%/12) = $41.67 → Balance: $10,041.67
- Month 2: $10,041.67 × (5%/12) = $41.84 → Balance: $10,083.51
- …and so on…
- After 12 months: $10,511.62
The APR was 5%, but you earned $511.62—which is 5.12% of your original $10,000. That 5.12% is the APY.
The formula: APY = (1 + APR/n)^n - 1, where n is compounding periods per year.
How compounding frequency affects APY
Same 5% APR, different compounding:
| Compounding | APY |
|---|---|
| Annually | 5.00% |
| Quarterly | 5.09% |
| Monthly | 5.12% |
| Daily | 5.13% |
The difference between monthly and daily compounding is tiny (0.01%). The difference between annual and monthly is more meaningful (0.12%). For most purposes, monthly compounding captures nearly all the benefit.
APR on loans and credit cards
When borrowing, APR is the mandated disclosure under the Truth in Lending Act. It must include certain fees beyond just the interest rate, making it useful for comparing loan offers.
However, APR understates your actual cost when interest compounds:
Credit cards typically compound daily. A 24% APR compounds to about 26.8% APY. On a $5,000 balance carried for a year (no payments), you’d owe approximately $1,340 in interest—not the $1,200 that 24% implies.
Mortgages compound monthly, but because you’re making payments (which reduce principal), the compounding effect is less dramatic than on revolving debt.
Student loans vary. Federal loans use simple daily interest; private loans may compound differently. Check loan terms for specifics.
APY on savings and investments
When saving, APY tells you what you’ll actually earn. Banks are required to disclose APY on deposit accounts under Regulation DD.
Savings accounts show APY because it’s the higher number. A 5% APY account actually has a ~4.89% APR that compounds to reach 5%.
CDs show APY. A 1-year CD at 5% APY will return exactly 5% on your deposit over the year (assuming interest reinvests).
Money market accounts show APY. Compare APYs directly when shopping for the best return.
For savings, higher APY is always better. The comparison is straightforward.
When APR and APY are equal
If interest doesn’t compound (simple interest only), APR and APY are identical. This is rare in consumer finance but occurs in some contexts:
- Certain loan calculations
- Treasury bills (sold at discount, no compounding)
- Some promotional rates
When someone quotes a rate without specifying APR or APY, ask which one they mean—or calculate the other yourself if you know the compounding frequency.
Practical applications
Comparing savings accounts: Use APY. A 4.95% APY account beats a 4.90% APY account, regardless of how each bank calculates interest internally.
Comparing credit cards: Use APR for initial comparison, but understand that the effective rate is higher. A 20% APR card is meaningfully better than a 24% APR card—about 4 percentage points of actual cost difference.
Comparing loans: APR is designed to include fees and enable comparison. A mortgage at 6.5% APR with $3,000 in fees might beat one at 6.25% APR with $8,000 in fees, depending on how long you hold the loan.
Understanding credit card interest: If you carry balances, your effective cost is higher than the stated APR. Paying off credit card debt eliminates this compounding working against you.
Maximizing savings returns: Small APY differences matter over time. An extra 0.25% APY on $50,000 in savings is $125/year. Worth 10 minutes to find a better account.
The compound interest connection
APY is essentially the answer to “what does compound interest actually produce over a year?” It takes the nominal rate (APR) and shows the real result after compounding does its work.
When building wealth, compounding works in your favor—APY shows how much. When paying interest, compounding works against you—APY shows how much worse it really is.
Understanding this distinction is part of understanding how money grows (or how debt grows). The same mathematical principle applies to both—you just want to be on the receiving end.
Quick reference
When you’re earning interest (savings, CDs, investments):
- Look at APY
- Higher is better
- Compare APYs directly
When you’re paying interest (loans, credit cards):
- APR is the disclosed rate
- Actual cost (APY equivalent) is higher
- Lower is better
- For credit cards, don’t carry balances if possible
The financial industry uses both terms strategically. Now you know why.
Historical context
Before standardized disclosure laws, lenders could advertise rates in whatever way looked most favorable. A loan might be marketed as “6% simple interest” while actually costing much more due to fees, compounding, and fine print.
The Truth in Lending Act (1968) and Truth in Savings Act (1991) standardized disclosures. APR for lending and APY for deposits became required metrics, enabling consumers to compare apples to apples.
These regulations weren’t perfect—some fees aren’t included in APR, and banks still emphasize whichever number looks better—but they improved transparency significantly. Understanding what’s disclosed and why helps navigate the remaining complexity.
The bottom line
APR and APY measure the same underlying concept (annualized interest rate) with different treatments of compounding. The difference matters whenever:
- You’re comparing savings account options (use APY)
- You’re evaluating loan costs (use APR, but understand actual cost is higher)
- You’re calculating investment returns (APY/effective rate shows actual growth)
- You’re deciding whether to pay off debt vs. invest (compare like terms)
Financial literacy includes knowing when you’re looking at APR vs. APY and understanding what each means for your actual dollars. The distinction seems technical but translates directly to money earned or paid.
Converting between APR and APY
If you know one and need the other:
APR to APY: APY = (1 + APR/n)^n - 1 Where n = number of compounding periods per year
APY to APR: APR = n × [(1 + APY)^(1/n) - 1]
For monthly compounding (n=12):
- 5% APR → 5.12% APY
- 5% APY → 4.89% APR
Most financial calculators and spreadsheets can handle these conversions. Or use online tools—searching “APR to APY calculator” provides instant results.
The conversion matters when you’re trying to compare products that disclose different metrics, or when planning how much interest you’ll actually pay or earn over time.