Financial Literacy Month: APR and APY

by Matt B

APR, or Annual Percentage Rate, is the annual payment based upon a 12 month cycle. There are many misconceptions and questions about APR. APY, or Annual Percentage Yield, is the annual return of investment based upon a 12 month cycle. There are also many questions and misconceptions about APY. I will do my best to clarify both.

Annual Percentage Yield (APY)
A few days ago, a young customer at work came to me, frustrated about her return on a recently opened Money Market savings account. The way she looked at it, since interest on this account is paid monthly, the return on her $10,000 account at 2.05% APY should have been 205 dollars. I do not recall the actual payment, but it was somewhere around 17 dollars. What she did not understand is that the 2.05% interest offered on the account, although paid monthly, is an annual yield. So, through 12 months the interest earned on her balance would be 205 dollars, but it is paid in 12 monthly increments. Although she was frustrated, nobody had ever explained that the advertised interest rate is for 1 year.

Annual Percentage Rage (APR)
Similarly to APY, APR is the interest paid over a 12 month period on a loan, mortgage, credit card, etc. What does that mean for you? Let’s say you have a 30 year mortgage at 5% APR. If the amount borrowed for the home is $200,000.00 your total after 30 years of regular payments will look like this:

Monthly Payment:

$1074.64

Total Loan:

$200,000.00

Total Interest Paid:

$186,511.57

Total Paid in interest and principal:

$386,511.57

Since the 5% interest rate is an annual rate, instead of paying a simple $10000 in interest ($200,000/5%) you are paying the 5% annually on a 30 year loan, making the total interest payment much higher than 5% of the entire loan.

I realize that may have been a bit much to swallow, so let’s look at APR on credit cards. For example’s sake, let’s say you have a $2500 balance on a credit card with a 10% interest rate. Since you are paying 10% APR, that means that your interest charges every month will not equal 10% of your bill. I imagine if your interest rate was tacked on at the end of every billing cycle, we would have a lot more riots. So, to make it readable, you see a daily percentage rate on your credit card bill. If your interest rate is 10%, your daily percentage rate will be .0274 (rounded to the nearest thousandth). That is how your monthly interest is calculated and interest is billed to you every month.

I realize that this post had a lot of technical talk and numbers. Sometimes it may be confusing, but in order to become financially literate, discerning the difference in terminologies is a necessary obstacle.

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