APY Vs. APR: Understand The Difference for Your Student Loan
Although the terms APR (annual percentage rate) and APY (annual percentage yield) sound almost identical, they have major differences. Confusion over the terms is understandable since both are widely used to calculate interest on loans and other investments. Depending on the method used, your loan repayment amount may vary significantly.
For starters, the annual percentage yield uses compound interest while the annual percentage rate doesn’t. The quicker this cost compounds, the more prominent the difference between APY and APR.
Understanding the differences and how each metric is calculated will help you better understand how much you should be paying on your student loans.
What Is APY - Annual Percentage Yield?
What does APY mean? As previously mentioned, it stands for annual percentage yield. Some lenders also refer to it as earned annual interest (EAR). This can be defined as the interest rate charged for earnings or borrowing over a year. There are two types of APY or EAR: single annual payments and monthly compounding.
To better understand how APY works, you’ll need to first have a clear idea of what compounding is. At a basic level, it means earning or paying interest on an already accumulated amount of interest. This number is usually added to the outstanding principal of your student loan. Most lending products, as well as investments, use this method.
How do you find APY?
Banks calculate it using the following method:
APY = (1+ R/N)N – 1 [where R=rate of interest and N-= number of compounding periods per year]
Based on this formula, let’s say you have a student loan at a 6% annual rate and the interest on the principal compounds monthly (12 times a year). This means your total cost for the loan will be 6.17%. So, if your balance was $5,000 initially, it would be $5,308.39 by the end of the year.
If the same amount was compounded annually (once per year), your total balance would be $5,300. This difference might not look substantial at first glance. However, it can accumulate quickly when your student debt repayments span across 20-25 years.
You need to be very cautious about how lenders might disguise a loan as having a lower rate. Usually, borrowers are always looking for the lowest rates, but if you don’t read through the fine print, you may end up paying more on your student loan account than you originally anticipated.
What Is The Difference Between APR And APY?
The major difference between the two is how the interest is compounded. In the simplest terms, the faster it compounds, the higher your total debt or income. While the annual percentage yield is mostly used for investments, the annual percentage rate is used to calculate the annual cost of debt one pays. This amount also includes any lending product fees.
Banks advertise annual percentage yield for savings accounts, investments, CDs. If you find a savings plan with a higher EAR, your money will grow faster because of compounding. Likewise, APR (fixed and variable rate) is primarily used for borrowing. If you’re applying for a student loan, auto lending product, or any other debt, you’ll want this number to be as low as possible. The lower the APR, the less you’ll pay over the full tenure.
The calculation for both also varies. Here’s how each is calculated:
- APY = (1+ R/N)N – 1, [where R=rate of interest and N-= number of compounding periods per year]
- APR = P (1 + R x T), [where P= principal, R=rate of interest and T= time period]
To give you a clearer picture, let’s consider a numerical example. You deposited $10,000 into your savings account, which has an APR of 6%. If the bank only applies the interest once every year, your account balance at the end of the financial year will be $10,600 ($10,000 + 6% of $10,000).
On the other hand, let’s assume that your bank compounds the 6% interest quarterly. This means that the 6% will be broken down into four equal installments for each quarter, thus amounting to 6.13% at the end of the year.
Based on this example, you can see that there’s a 0.13% difference. While this may not seem like much, imagine the extra amount you can save if you deposit the $10,000 for a more extended period.
When it comes to borrowing, you need to run the numbers. For example, you connect with a lender who agrees to provide you with a loan at a 12% rate to be paid monthly. This means that the lending company needs you to pay one-twelfth of the annual rate every month (1% per month). However, when you take into account the compounding factor, the rate will be 0.1268% per month. So, according to the formula, the lender is charging you 12.68% and not 12% on the loan.
APR, APY, And Interest Rate - How To Compare Loans
You should always compare APR to APR and EAR to EAR, rather than comparing the two. Both terms are used differently and can impact your finances over an extended period.
Usually, financial institutions advertise investment opportunities with attractive annual percentage yield. This is mainly because its formula is designed to yield higher returns. Hence, you can see a certificate of deposits, mutual funds, savings accounts, and so forth being associated with this rate.
On the other hand, APR is associated with borrowing. It doesn’t use compounding. As a result, your interest charges remain minimal over the term of the lending product. That said, the APR for student loans can be fixed or variable based. Private student loans, student debt refinancing, credit cards, and other personal lending products are often promoted with this method.
To assess the true difference between the two, we recommend using online calculators. If a lending product or an investment is advertised with an APR, these calculators can help you easily convert it to an annual percentage yield. All in all, it enables you to visualize how much interest you’ll pay or earn.
What Does It Have To Do With Choosing A Student Loan
Surprisingly, interest rates advertised on federal student loans don’t specify if it’s in APR or APY. On the other hand, private student loans are very specific about the type of interest they charge. If you’re unclear about these terms, just keep in mind that “A” denotes “annual.” It’s the amount you’ll pay after a year.
Whenever you’re comparing student loans, make sure to convert APR to APY. This will help you get a better idea of how much you’ll pay over the whole tenure.
For instance, you have a student lending product with a 6% annual rate. If this number doesn’t compound, it remains the same at the end of the year. If it’s compounded monthly, your total interest will be 6.17%.
Bottom Line
Understanding the differences between how each rate of interest is calculated can help you define your budget and get precise estimates of what you’ll earn or pay over the life of a deposit or loan. In general, compounding is related to savings, and a fixed or variable rate is related to borrowing.
If you’re applying for financing, we recommend that you use an online calculator to convert APR to EAR to understand the exact student loan interest rate offered by different lenders.
