Learn About APR, APY and EAR Interest Rates
Point of Interest
While APR, APY and EAR all deal with the same topic and the terms are often incorrectly interchanged, each term is not the same. A common distinction is that APR represents the cost of borrowing and APY the amount you’ll earn on an investment or deposit.
Whether you’re borrowing money or investing, you’ve probably heard the acronyms APR, APY and EAR. Each of these terms represents a method for detailing the cost of borrowing or representing the money you’ll earn through interest when investing. While each term is similar, there are marked differences that can affect your finances. Understanding these differences can equip investors and borrowers with the power to better make informed financial decisions.
What is an APR?
APR stands for annual percentage rate and represents the cost of borrowing money. This cost of borrowing is the amount a lender, bank, credit union or other financial institution will charge you every year for access to these funds. An APR rate is represented as a percentage of the principal, also known as your loan amount. APR differs from the interest rate as it includes any applicable fees that you might be charged along with the interest.
This metric gives a much clearer picture of the actual amount of money you’ll be charged for borrowing. It’s of notable importance that APR does not include the effects of compound interest. This does not matter with loan types that use simple interest, as there are no compounding effects to account for.
For this reason, you’ll see APR used when looking at loans like mortgages and auto loans. However, with borrowing methods that do use compound interest like credit cards, it can paint an incomplete picture.
What is an APY?
APY is an acronym that stands for annual percentage yield and details the amount you’ll earn on an investment product like a savings account, money market account or certificate of deposit over a year. This metric does factor in compound interest, which gives you the clearest picture of what you stand to earn on an account for 12 months. Like APR, APY is presented as a percentage of the money you have invested.
What is an EAR interest rate?
As mentioned, APR gives the cost of borrowing for the year with applicable fees included. APR is a much better metric than just looking at interest rates for all forms of borrowing. For borrowing products that don’t have compounding interest (like auto loans, mortgages and personal loans), APR is the crème de la crème.
However, what happens when you’re using a borrowing product that uses compounding interest like a credit card? An effective annual percentage rate is APR that takes into account the effects of compounding interest. With these products, this is the most accurate assessment of what you’re going to pay to borrow that money for the year.
If interest is the most basic calculation of borrowing costs, then APR is the next step up and adds the cost of fees to the calculation. This is all you need for simple interest loans. APR will be higher than the interest rate. Then, EAR takes APR to the next level and adds in the effects of compound interest. This is only necessary for borrowing tools that use compound interest. When compounding interest is present, the EAR will be higher than APR.
APR vs. interest rate
An interest rate tells you the additional percentage you will have to pay on a sum of borrowed money as the cost of borrowing. Interest rates also tell you the additional percentage of the money you will earn on an invested sum of money.
APR only deals with borrowed money. It takes the interest rate for the year and adds in the cost of fees you will have to pay. This gives you a much more complete picture of what you’re going to pay. Often, people tend to look at the interest rate and forget to look at associated fees that drive up the true cost of borrowing. APR solves that shortcoming giving borrowers the ability to compare options across a level playing field.
APR vs. APY
APR and APY are similar but deal with different sides of the investing and borrowing equation. APR is used when you’re looking at the cost of borrowing money for the year. APY, on the other hand, is used when you’re looking at how much you’ll earn on the money you’ve invested. The other major difference between APR vs. APY is that APR does not calculate in the effects of compound interest — APY does.
APR vs. EAR interest rate
The difference between APR and EAR is small but can have a significant impact on some forms of borrowing. APR gives you the total costs of borrowing for the year without taking into account the effects of compound interest. Unlike interest, though, it does take into account the applicable fees you’ll need to pay for borrowing.
EAR takes into account everything that APR does but goes a step further by including the effects of compound interest. This may lead you to wonder why we would ever use APR and not just use EAR all the time. The reason for this is that many borrowing products use simple interest and do not compound. Trying to use a metric that calculates compound interest on a product that doesn’t have compound interest is not needed.
Auto loans, mortgages and personal loans don’t use compounding interest, and therefore can be compared effectively using APR. However, credit cards do compound interest daily or monthly. Because of this, you need a metric like EAR that takes this into account.