When looking at financial packages, you will often come across the terms “annual percentage yield” and “annual percentage rate”. At first glance, they may appear similar, if not identical, but they relate to different types of financial packages:
- Annual percentage yield (APY) is more commonly associated with savings and investment accounts.
- Annual percentage rate (APR) is more related to financial products like loans and credit cards.
What is the Annual Percentage Yield (APY) figure?
The APY figure reflects the actual annual interest earned on savings, investment accounts and certificates of deposit. The frequency at which interest is added to the account influences the APY (rate of return). As such, APY can differ from the headline rate of interest. The method for calculating the APY for a savings account is straightforward.
To simplify the situation, we will assume that a deposit of £1000 is made at the beginning of the year, held for 12 months, and the interest rate is 10%. Therefore the annual, quarterly, and monthly interest calculations are as follows.
Where interest is applied annually, it is merely a case of taking the balance at the end of the year and adding the interest. So, using the example above, with a headline interest rate of 10%, the amount of interest generated would be £100 per annum.
If interest is applied quarterly, i.e. every three months, the account balance will increase every three months. However, each quarter’s interest rate will be the headline interest rate divided by four. So, for example, if the headline interest rate were 10%, the quarterly interest rate would be 10%/4, which equals 2.5%. Therefore the amount of interest accumulated would be £103.81.
Accounts which apply interest monthly use the headline rate, for example, 10%, and divide this by 12 for each month. In this case, 0.83% of the monthly balance would be added to your account as interest. The balance for the following month will include the interest from the previous month, leading to the compound impact of interest on interest. This equates to an annual interest of £104.71.
Examples of APY
To demonstrate the impact of APY, we will look at a savings account with a simple interest rate of 10% per annum, where £1 million has been deposited. We have calculated three examples:
- Annual interest
- Quarterly interest
- Monthly interest
We need to consider the simple interest rate and the APY to choose the best savings account.
Interest applied annually
When adding interest annually, interest is calculated on the balance at the end of the 12 months. In this instance, 10% interest on £1 million equates to £100,000. Therefore, the balance at the end of 12 months is £1.1 million.
We have also calculated the interest earned at the end of year two, which is summarised as follows:
Interest applied quarterly
In the following example, the interest is applied every three months and added to the account balance.
As interest is added quarterly in this instance, i.e. every three months, the balance at the time has interest of 2.5% added (10% divided by four). The impact of compounding interest every three months leads to a degree of interest on interest. Consequently, at the end of the 12 months, the interest earned is £103,813, equating to an APY/annual rate of 10.38%.
The greater the number of periods in which interest is added each year – compounding periods – the higher APY due to the impact of interest on interest. The frequency of compounding periods over the year is critical to the interest earned on your bank account. Consequently, knowing how individual financial institutions calculate interest on deposit accounts is vital.
The following summary illustrates the impact of quarterly interest over two years:
Interest applied monthly
Our final example shows the impact of adding interest more often, in this instance, monthly. As a result, more interest is earned on interest, leading to a higher interest payment over 12 months.
The above table shows the impact of adding monthly interest to the account at a rate of 1/12 of the headline interest rate. Therefore, the total interest for the 12 months increases to £104,713, generating an APY of 10.47%.
The impact of monthly interest added to your account over two years is as follows:
The power of compound interest may be subtle when looking at headline interest rates and APYs. However, it will help to earn interest at a faster pace.
We aren’t suggesting that the APY will transform a low-yield savings account into a high-yield savings account. But it will put more money in your pocket. In monetary terms, this is especially relevant for large money market accounts.
What is the Annual Percentage Rate (APR) figure?
APR is more commonly quoted when it comes to personal finances and financial products, often relating to personal loans and credit cards. This is because it reflects the “real” cost of borrowing money, considering the loan amount and compound interest and additional charges.
The long-term effect of compounding interest can be significant. Therefore, the lower the loan term, the less impact compound interest will have on the overall cost of borrowing money. Knowing the terms of any line of credit before you apply is essential.
Repayments on a personal loan are straightforward. For example, for a 12-month loan of £10,000 at a rate of 10%, the total payment would be £11,000. Spread over 12 months, this equates to £917 per month. However, this rate would change if, for example, the lender also charged a setup fee.
You will see the headline interest rate and the APR when considering credit cards. Most credit card companies add interest monthly. So if you don’t at least repay the interest in full each month, you will be paying interest on interest in future. To maintain control, credit card companies require a minimum payment each month defined as X% of the balance, interest + X% or £X.
Examples of APR
We will now look at real-life examples of APR, how it is calculated and how it should impact your decision-making process.
Calculating the APR of a personal loan
In the above example, we have a £10,000 loan over 12 months at a rate of 10% – straightforward. However, the situation becomes a little more complicated if additional fees like a setup fee exist. In this example, we will assume a setup fee of £100.
While the client borrowed £10,000, the debt from day one is £10,100, including the setup fee. Consequently, the interest charged on this loan is higher at £1010 (10% of £10,100) against just £1000 when there was no setup charge. So while the headline interest rate remains the same at 10%, the APR is actually:
100*(£1010 / £10000) = 10.1%
As the setup fee is added to the loan value, you are paying interest on the principal amount and the £100 setup fee. Under the Consumer Credit (EU Directive) Regulations 2010, finance providers were legally obliged to include the APR when marketing financial products.
Calculating the APR of a credit card
Most credit card companies charge interest monthly, which they add to your balance. Some companies may even charge interest daily, which further increases the impact of compound interest. It is important to note that traditional credit cards will also require a minimum 1% payment of the monthly balance.
The following table illustrates interest and repayments on a credit card, with a headline interest rate of 20%, charged monthly (1.66%) and a 1% minimum balance repayment each month:
The above table gives a real-life example of how credit card interest and monthly repayments work:
- The monthly interest rate is 1.66%, and the minimum balance repayment is 1%, which means that net interest of 0.66% is added to the account balance each month.
- Over the 12 months, £1,265 was repaid to the credit card.
- As monthly repayments did not fully cover interest charges, the accumulation of interest (and the impact of interest on interest) saw the balance increase by £918.
- Annual interest payments totalled £2,073, but they would have been £2,194 without the impact of regular monthly repayments.
Credit card companies charge interest this way because credit card balances will vary from month to month. Many would describe the APR as the real cost of the credit card.
APR vs APY
It is vital to be aware of the impact of APY and APR when considering different financial products. The “real” interest rate is heavily impacted by the frequency at which interest is added to the account, whether a credit card or savings account. When it comes to personal loans and credit cards, where the APR is important, you also need to consider any additional charges. Traditionally, these additional charges are added to your loan or credit card balance, and you will pay interest on those as well.