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Quite a number of readers had written in asking me to explain the difference between APR and APY.
APR = Annual Percentage Rate. Think of this as simple interest.
APY = Annual Percentage Yield. Think of this as compound interest.
APR and APY explain why your Fixed Deposit certificate quotes an interest rate of 9% but upon maturity you get an interest amount that is slightly higher than what you’d actually get at 9%.
APY = APR compounded at a certain compounding interval.
The exact formula that relates these two is:
APY = (((1 + (Quoted_APR/100)/Compounding_Interval)^Compounding_Interval) – 1)*100
APY = (((1 + (10.25/100)/4)^4) – 1)*100 = 10.65%
On the other hand, if APR = 10.50% and compounding is done quarterly then,
APY = (((1 + (10.50/100)/4)^4) – 1)*100 = 10.92%
Finally, if APR = 10.25% and compounding is done semi-annually then,
APY = (((1 + (10.25/100)/2)^2) – 1)*100 = 10.51%
That explains the difference between APR and APY. Let me know if you have any questions.
Note: With Credit Cards you might sometimes see a monthly-APR quoted such as 3.1% per month. Simply multiply this by 12 to get the annual-APR. In this case, the annual-APR is 3.1% x 12 = 37.2%.
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