Can someone explain in Lay terms the difference between APR and APY?

Question

specifically annual percentage yeild.... how is it different?

Answer 1

A lot of people misuse the term APR. APR and APY are used in two totally different situations. APR is used in lending and represents the true cost of a loan in percentage terms when fees are taken into consideration. APY is used in interest bearing savings type sitautions and represents the return on funds one would recive after taking into consideration the compounding of interest assuming the funds are held on deposit for 1 year.

The difference between the APY and the stated annual interest rate is the return provided from the compounding of the interest during the year. The APY is important to enable depositors to easily compare cds without having to calculate the actual return from the stated interest rate and the frequency of compunding.

Example:
If you were comparing 2 cds and Bank A offered a cd with a stated rate of 5.00% and Bank B offered a cd with a stated rate of 5.01% which one would you choose? While you would probably choose bank B because the stated interest rate is higher to make the correct decision, you need to know the frequency of compounding and that is what the APY takes into consideration. If Bank A compunds interest monthly and Bank B compounds quarterly the APY on Bank A would be 5.12% and the APY on Bank B would be 5.10% so you would have more money after one year by depositing your funds with Bank A due to the higher compounding frequency even though the stated annual interest rate is lower. This is why banks are required to quote interest bearing savings products in terms of APY.

Answer 2

Basically, the APR (annual percentage rate) is used to help consumers understand the total cost of borrowing money (e.g. mortgages, auto loans, credit cards, etc.). In the US, this number is somewhat standardized and includes fees and interest over the life of a loan.

On the otherhand, APY (annual percentage yield) is typically used to illustrate the returns for savings and investment products (e.g. bank CDs, money market funds, etc.). The quantity takes into effect compounding--the amount of interest earned on interest.

See the following links for more information (and some math):

http://en.wikipedia.org/wiki/Annual_percentage_rate
http://en.wikipedia.org/wiki/Annual_Percentage_Yield

Answer 3

The difference is in compounding. You can get a little more money if the interest is paid more often. 4% interest paid daily instead of yearly pays 4.08 APY vs. 4%. This is because you get interest on interest... not a lot at first, but it adds up.