APR vs. APY: What’s the Difference?

Annual percentage rate (APR) and annual percentage yield (APY). They sound the same, but actually major differences that lead to distinct outcomes when calculating an investment’s expected return.

It’s crucial that investors in lending products like private credit understand APR and APY, including the differences between the two, and when to use each in your expected return calculations.

In this article, we'll explore those differences through investment examples, and explain how APR and APY can be applied in various scenarios. Whether you're evaluating consumer loans or credit cards, or comparing investment opportunities, understanding these concepts will empower you to make informed decisions.

Key Takeaways

• APR represents the annual cost of borrowing, factoring in interest rates and fees, but not compounding. APY, in contrast, accounts for the effect of compounding interest, offering a more accurate picture of potential earnings on investments
• The choice between APR and APY depends on the nature of the financial decision, with APR being more relevant for borrowing money and making investments without compounding interest, while APY comes into play where compounding is part of the overall investment strategy
• Understanding the frequency of compounding is crucial when calculating APY, as it significantly affects the total return of the investment

What is the Difference Between APR and APY?

Distinguishing between APR (Annual Percentage Rate) and APY (Annual Percentage Yield) is vital for anyone engaging with financial products, as each highlights a different aspect of lending.

Quite simply, APR is the cost of borrowing. It denotes the annual rate for borrowing money, encapsulating not just the interest rate but also any additional fees. Unlike APY, it excludes the impact of compounding interest throughout the year, making APR a pivotal metric for evaluating the true cost of loans.

APY, in contrast, can be defined as the earnings on a loan. It accounts for the interest earned, while also factoring in the role of compounding interest. The frequency of compounding—be it daily, monthly, or annually—elevates APY over the nominal rate, showcasing the potential growth of savings or investments.

APR is often used by lenders as it denotes the true cost of borrowing money.^[1] APY is used by banks and investment companies, as it encapsulates the growth of an investment over time, via compound interest.^[2]

How APR and APY Can Lead to Different Returns Over Time

When examining APR and APY, it's essential to understand their impact on investment outcomes. Consider an investment with a 5% APR and another with a 5% APY. Despite appearing similar, their returns diverge–especially over long time periods.

Since APR excludes the effects of compounding, investing $1,000 at a 5% APR yields $50 after one year. APY incorporates compounding (over a given frequency). So if we assume monthly compounding, then the same $1,000 investment with a 5% APY will yield $51.16 after one year.

That means the effective annual rate for the investment on an APR basis is 5% ($50 earned after one year), and on an APY basis is 5.12% ($51.16 earned after one year).

The more frequently interest is compounded, the greater the difference between APR and APY, resulting in potentially higher returns on an APY basis over time.^[3] This is ‘the magic of compounding,’ which you’ve probably heard about in the context of the stock market. The same is true for investments into loan products, assuming investors reallocate their interest earned back into the underlying investments.

How to Know When to Use APR or APY?

Understanding the distinction between APR and APY is crucial for investors aiming to make informed financial decisions. These metrics serve different purposes and are not interchangeable, highlighting the importance of context in their application.

APR is straightforward for simple interest scenarios, focusing on borrowing costs or basic returns. APY offers a deeper insight into earnings from investments benefiting from compound interest, such as savings accounts or certificates of deposit.

For investors, that means choosing APR when their strategy is to collect the interest earned and not redistribute that interest as further investment into their portfolio. If investors are planning to reinvest their earned interest, they should calculate their expected return using APY. By contrast, borrowers generally use APR as the borrowing cost. For example, individuals can use APR when considering credit cards or consumer loans (in other words, when the individual will be borrowing money).

Heron Finance targets an APY of 11-16% on its investments, net of any fees. So that target is assuming investors will reinvest their earned interest. Of course, investors on Heron Finance have the option of collecting their interest payments and withdrawing them from their Heron Finance account. If investors are approaching their Heron Finance investment this way, they should calculate a simple APR in their financial projections.

In Conclusion

Understanding the nuances between APR and APY is crucial when considering borrowing options or seeking the best returns on investments. APR gives a clear picture of the cost of borrowing, making it useful for comparing loans or credit cards. APY provides a deeper insight into the potential earnings from investments, especially those that benefit from the power of compounding interest.

By making informed decisions based on these metrics, investors and borrowers alike can optimize their financial strategies and achieve better outcomes.

To learn more about how interest rates work in the private credit sector specifically, read our deep dive article here.