APR and APY are two financial metrics commonly used to describe a product’s performance. Although they are both interest rates, they differ slightly in how they are calculated and presented.
The APR (Annual Percentage Rate) is the total return on a financial product expressed as a percentage of the amount invested. It often comes down to the nominal interest rate of a product.
It’s important to note that the APR does not take into account when interest is capitalized or the timing of payments. Therefore, the APR does not necessarily reflect the income generated by a financial product in situations where interest is capitalized more frequently than annually. In these cases, it is recommended to use the APY to get a more precise idea.
The APY (Annual Percentage Yield), or annual rate of return, takes into account the effect of compounding, that is to say the moment when interest is added to the initial capital to produce new capital.
The APY is calculated using the following formula:
APY = (1 + r/n)^n – 1
with :
r: nominal interest rate,
n: number of times interest is capitalized per year.
Here is an example to clearly illustrate the difference between these two rates.
Consider a $1,000 loan with a nominal interest rate of 5%, a repayment period of 1 year, and interest paid monthly (i.e. 12 times per year).
For the APR, the calculation is simple: the nominal interest rate is 5%, so the APR is also 5%.
For the APY, the calculation is as follows:
APY = (1 + 0.05/12)^12 – 1 = 0.0511618983
The APY rate in this case is therefore 5.116%.
