Banking Basics: APY vs. Interest Rates vs APR Compared

APR, APY, and interest rates are often used interchangeably to talk about financial accounts, they shouldn’t be. While they are indeed similar, the outcome is not, it’s like comparing “apples to oranges”. To help, we’ve broken down what they all mean and how they compare, then we dive into an example so you can see why the actual metric used matters, let’s dive in!

What are interest rates?

Interest rates refer to the annual cost of a loan to a borrower, expressed as a percentage. They may also be used to express the amount you’ll earn for storing deposits in a bank.

The interest rate provided by your bank is exclusive of fees and other charges associated with the loan. Interest rates are typically higher for credit cards and other forms of consumer loans, and lower for mortgages and other long-term loans. Comparing the interest rate across banks is an apples-to-apples comparison.

What is APR?

The annual percentage rate (APR) is used to calculate the total cost of borrowing money or taking out a loan. It considers the amount of interest that is charged, as well as any additional bank fees or charges associated with the loan. It is typically expressed as a percentage of the loan balance, and it is used to compare different offers and determine which is the best deal. The APR will always be higher than the interest rate

What is APY?

The annual percentage yield (APY), represents the total return that you can expect to receive from a savings account, money market account, or treasury account over a year. APY is calculated by taking into account the compounded return generated each month minus any associated fees.

What is the difference between the APR and the interest rate? 

As mentioned above, the APR you are quoted is inclusive of the fees and bank charges, but the interest rate is not. Banks provide the APR because:

• They’re required to by the Federal Truth in Lending Act
• It's helpful for understanding the total cost of a loan
• It enables borrowers to compare offers side by side.

Since all lenders must follow the same rules when stating the APR, they effectively can’t hide any of their bank fees. You may come across APR if you are seeking venture debt, mezzanine financing, or another form of debt.

What is the difference between interest rates and APY?

APY is different from interest rates because it takes into account compounding. As such the APY will always be higher than the interest rate. So, if you are comparing the return of two accounts, make sure you compare APY to APY, not the APY of one account to the interest rate of another. Note: most banks will quote the APY of an account rather than its interest rate.

What is the difference between APY and APR?

APY and APR are completely different. While APY is used to describe the return on deposit accounts and investments, APR is used to describe the total cost of a loan. In other words, APY is a measure of the interest earned and APR is a measure of the interest charged. If you are comparing accounts or offers, you’ll want to maximize your APY and minimize your APR.

How do banks determine the interest rate?

To be frank, the interest rate banks charge for loans is a black box. It is handled completely differently at each bank or financial institution, and few guardrails specify what they can or can’t do. If you gave two banks the same deal criteria, and the same information on the borrower, they would likely come back with two completely different numbers. Why? Because banks have different risk tolerances, different revenue targets, and ultimately different philosophies on who is a “good borrower”.

A similar thing happens in the world of deposits. Some banks pay 0.01% on deposits, while others pay upwards of 4.00%. Why? Simply because they can. While the base rate is set by market factors, including the Federal Reserve’s current requirements, ultimately, the banks can decide how much they will pay out. For a more in-depth look, check out the article we wrote in Forbes on why startups and small businesses are flocking to fintechs.

How often does interest work and how often does interest compound?

This is another really interesting question because banks can set their compounding schedules. According to the Consumer Financial Protection Bureau, banks are required to calculate interest on the “full amount of principal in an account for each day by use of either the daily balance method or the average daily balance method.”

What this means in practice, is that they must take the interest rate divided by 365 (or 366 in leap years) and perform interest calculations based on the balance in the account each day. Which seems fair, right? Well, it sort of is.

The issue is that banks can choose to pay out that accrued interest whenever they wish. Once a week, once a month, once a quarter, or even once a year. Meaning that even though you earn interest each day, that interest may not necessarily be credited and compounded each day. 

Section § 1030.7 Payment of interest, subsection 7(b) states: “Institutions choosing to compound interest may compound or credit interest annually, semi-annually, quarterly, monthly, daily, continuously, or on any other basis.” The result is your money doesn’t grow as fast as it could.

On the flip side, because banks and lenders can choose whatever compounding schedule they’d like, they can add interest charges to your balance and compound it daily. This isn’t the norm, as most banks compound monthly, but there are horror stories all over the internet about it. The moral of the story is to ask your bank how often they credit or charge interest and what compounding schedule they use, before signing on the dotted line.

How often do interest rates change?

While most banks will try to convince you that interest rates only change once a month, the reality is that they change daily. Businesses in the process of securing a commercial mortgage loan realize this firsthand when trying to determine when to lock in their rate. Why do they change so much? In short, it's due to the constant and systematic repricing of risk in the market. Overnight rates can skyrocket such as what happened in 2022 when rates jumped 75 basis points (0.75%).

Will the rate, APR, or APY I was quoted change?

This depends on the type of loan or debt instrument you have. If it has a variable interest rate, or an “introductory rate” then yes it can (and likely will) change, but if it has a fixed rate, then it will not change unless you decide to either roll it or refinance it with another debt vehicle.

The APY for deposit accounts is typically always variable, which means it fluctuates with the market. The only exception is if you locked up your funds into a CD, T-bill ladder, or another structured financial instrument with a set maturity date. Check out this blog post for a more in-depth look at the mechanics of Yield.

Final thoughts on APY vs. Interest Rates vs APR

When comparing deposit accounts and loan offers, make sure to compare apples to apples: APY to APY, and APR to APR. Given the Federal Reserve is expected to continue raising rates throughout 2023, if you are looking for capital, try to lock in something that has a fixed cost, such as revenue based financing, rather than something variable. Remember that your goal should be to get the highest APY for your deposits and the lowest APR for any loans or debt. If you’re looking for a fee-free, high-yield savings account, check out Reserve from Arc.