Most investments or loans usually have interest rates associated with them. However, these interest rates have different names and implications for your pocket. Also, some of them are calculated per year while others are calculated periodically over the course of days, weeks or months.
That said, the easiest way to determine your interest rates is to annualize them. By doing so, you get an idea of what you pay over the course of a year. Learning how to annualized interest rates can be super helpful for keeping your personal finances in check.
Read More: 7 Kinds of Interest Rates
What Is the Difference Between APY And APR?
Annual percentage yield (APY) is the yearly interest rate set for your investments, such as savings in a bank account. It is usually expressed as a percentage and is based on a one-year period. People sometimes refer to it as the effective annual rate, or EAR.
It is worth noting that the annualized interest rate, expressed as APY, usually considers the compounding that has occurred over the course of that year. For example, if you invest in a bond that accrues interest twice a year, your annualized interest rate would be based on two compounding periods (12 months/6 months).
Generally, the more compounding periods there are in a year, the more interest your investments earn, even when compared to another investment with a similar annualized interest rate.
Read More: What Is Simple Interest?
On the other hand, the annual percentage rate (APR) usually represents the interest rates for any debts you take on, such as a mortgage or credit card balance. It’s mostly used by lenders (who are legally obligated to disclose it up front) because it does not consider the compounding of interest within a given year. Instead, it factors in the number of periods each year.
So, when it is used, the APR works on your money negatively, by reducing the amount you have each year since the interest is paid to another person or entity. However, it is stated in a way that makes your overall debt appear less over the long term.
Typically, the higher the annualized interest rate and the greater the number of compounding periods, the larger an amount becomes. If it is a debt, eventually, it can spiral out of control, which is common among people who carry credit card balances that have high interest rates. Currently, a typical American household has $5,315 worth of credit card debt.
Read More: What Is Compound Interest?
APR vs. APY: How to Annualize Interest Rates
Because APR only factors in the number of periods each year, you simply multiply the periodic rate by the number of periods. What you obtain as the total represents the annualized interest rate. It is sometimes referred to as a simple interest rate.
Its formula is:
APR = Periodic Rate x Number of Periods in a Year
For example, if someone offers to loan you money at 2 percent paid monthly, based on the formula, the annualized percentage rate or APR is:
APR = 2 percent *12, which equals 24 percent. So, in this case, you could say you obtained a personal loan at 24 percent APR.
So, if you were to borrow $10,000 at 24 percent APR, you would owe $2,400 as interest or $200 per month.
On the other hand, since APY factors in the compounding frequency. Its formula is:
APY = (1 + Periodic Rate) Number of periods-1
APY = (1+r/n )n-1, where r is the annual interest rate and n is the number of compounding periods.
So, suppose you made an investment with similar rates as above. In that case, if you were calculating APY:
APY = (1+(2/100))12-1 which is like 1.0212-1 and equal to 0.2682 or 26.82 percent.
Therefore, your investments would have an APY of 26.82 percent.
So, if you were to invest $10,000 at an APY of 26.82 percent, you would make $2,682 as interest in a year or $223.50 per month. That would be enough to offset the monthly debts stated above.
Now, suppose you made another investment at similar rates, except this time around, the interest is compounded twice a month. In that case, your annual percentage yield would be:
APY = (1+ (0.02/2))24-1, which is like 1.0124-1 and equal to 0.2697 or 26.97 percent.
As you can see from this latest example, the more times compounding happens, the higher the overall APY, which means you would make higher returns.
So, if you were to invest $10,000, you would make $2,697.34 per year or an average of $224.78 per month as interest.
Whether investing or taking a loan, you should first consider the annualized interest rates. That way, you can compare the returns of an investment or the cost of borrowing across multiple products so you can get a better idea of whether you are getting a good deal.
I hold a BS in Computer Science and have been a freelance writer since 2011. When I am not writing, I enjoy reading, watching cooking and lifestyle shows, and fantasizing about world travels.