02 - APR vs. APY: What's the Difference?

APR and APY sound almost the same, but one costs you money while the other makes you money. In this episode, Daniel and Shanna demystify these common but confusing acronyms with clear, real-world examples. We'll explore what APR (Annual Percentage Rate) really means for borrowers and why it includes more than just the interest rate. Then, we'll flip the script to explain how APY (Annual Percentage Yield) accounts for the magic of compounding interest, helping your savings grow faster. This is a foundational episode that will make you a smarter consumer and a more effective saver.

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Transcript

Episode 2 | APR vs. APY: What’s the Difference?

00:00:00 Daniel Hill: Shanna, have you ever been shopping for a car and seen a massive banner advertising zero percent financing? But when you actually sit down with a finance manager, the deal somehow isn't quite what it seemed to be.

00:00:14 Shanna Browning: So many times! Or you're looking for a great savings account and one bank is advertising a high rate, while another advertises a great yield, and you're wondering which one actually is going to make my money grow faster. It feels like the numbers are intentionally designed to just be confusing.

00:00:33 Daniel Hill: Exactly. And it's a language that if you don't speak it fluently, it's easy to get lost. The good news is it's a language with only a few key vocabulary words. Today we're decoding the two most important sets of letters in that puzzle -  APR and APY. Welcome back to Making Sense of your Cents, your podcast for quick, clear financial tips. I'm Daniel Hill.

00:01:08 Shanna Browning: And I'm Shanna Browning. Today we're going to tackle a topic that sounds complicated but is actually simple. Once you know the secret. The difference between APR and APY. These three little letters can either cost you thousands of dollars or make you thousands of dollars over time.

00:01:26 Daniel Hill: It's the language of money. One of these tells you the true all in cost of borrowing, and the other tells you the true compounding power of your savings. Understanding the distinction is one of the most fundamental skills for navigating your financial life with confidence.

00:01:43 Shanna Browning: So let's start on the side of the street where we owe money. We're looking at a credit card, a car loan or mortgage. The number we see on the front and center is APR. Daniel, break it down for us.  Tell me what it really means.

00:01:58 Daniel Hill: APR stands for annual percentage rate. The most important word there is annual. It's the total cost of borrowing money over a one year period, expressed as a percentage. But here's the critical detail that the law requires and that many people miss. The APR isn't just the interest rate. It must also include most of the lender's fees and other costs required to get the loan.

00:02:23 Shanna Browning: So when you say fees, what are you referring to?

00:02:27 Daniel Hill: This is key. For a mortgage, for example, it would include things like the loan origination fee, processing fee, other closing costs. For a personal loan, it could be an application fee. By bundling these upfront costs into a rate calculation, the APR gives you a much more holistic view of what you're actually paying.

00:02:47 Shanna Browning: My goodness, that makes so much sense. So it's like booking a flight. The interest rate might be the base airfare, but the APR is the final price  after all the taxes, baggage fees, seat selection charges are added in.

00:03:02 Daniel Hill: That's the perfect analogy. The APR gives you a much more honest apples to apples comparison between different loan offers, a lender might try to lure you in with a temptingly low interest rate, but if they tack on a high fee, the APR will be higher, exposing the true cost.

00:03:20 Shanna Browning: So if I'm comparing two car loan offers and an offer A has a 6% interest rate with one thousand dollars in fees, while offer B has a 6.5 interest rate with zero fees. The APR is the tool that helps me figure out which one is actually cheaper over the life of the loan?

00:03:40 Daniel Hill: Precisely, the APR calculation would make that one thousand dollars fee into the rate for offer A, so it's APR might end up being say 6.8%, revealing that offer B is the better deal. That's its entire purpose. It levels the playing field so you can compare a loan from a credit union, a bank and an online lender and know you're looking at the same type of number for any kind of debt. Your goal is simple find the lowest possible APR.

00:04:14 Shanna Browning: Well thank goodness, because that is incredibly clear. Lower is better when you owe. Now let's flip to the fun side of the equation. Earning money with APY.

00:04:26 Daniel Hill: Right APY stands for annual percentage yield. This is the number you want to focus your savings accounts, your money market accounts, or your certificate of deposits (CDs). The letter here is Y for yield. And the secret ingredient that makes APY so powerful. It's a concept that Albert Einstein supposedly called the eighth wonder of the world. And that is compounding.

00:04:51 Shanna Browning: And we hear that word all the time. The magic of compounding interest. Can you break down what's actually happening behind the scenes?

00:04:59 Daniel Hill: Compounding is simple. It's the process of your interest earning its own interest. Let's walk through a clear example. Let's say you deposit ten thousand dollars into a savings account that pays a simple five percent interest rate once a year after year one, you'd earn five hundred dollars. After year two, you'd earn another five hundred dollars. After twenty years, you'd have your original ten thousand plus ten thousand in interest for a total of twenty thousand dollars.

00:05:30 Shanna Browning: Now that's straightforward. But now I need you to show me the magic.

00:05:34 Daniel Hill: Okay, let's say that account compounds annually. After one year, you still earn five hundred dollars. So you have ten thousand five hundred dollars, but in two years, you earn five percent on the entire ten thousand five hundred dollars. So you'd earn five hundred and twenty five dollars. It's a small difference at first, but it's a snowball effect. By year twenty, that same account would have over twenty six thousand five hundred dollars. That extra six thousand five hundred is purely the result of your interest earning its own interest.

00:06:08 Shanna Browning: So you're telling me the APY calculation already includes the snowball effect?

00:06:13 Daniel Hill: Exactly. The APY tells you the effective annual rate of return, taking the compounding frequency into account. That's why you might see an account advertised with a 4.9% interest rate, but a 5% APY. That difference means the interest is compounding more than once a year, like daily or monthly. And the APY is showing you the true higher yield you will receive over a full three hundred and sixty five days.

00:06:39 Shanna Browning: So when our listeners are comparing two savings accounts, the APY is the only number that matters?

00:06:46 Daniel Hill: It's the only number that gives you the complete picture. Always look for the highest APY. It's the direct equivalent to the APR on the lending side. The most honest and complete measure of performance. Now, Shana, let's bust a common myth. A lot of people see a high APR on a credit card and say, twenty four percent and think, well, I don't plan on carrying a balance, so it doesn't matter. What's the danger in that thinking?

00:07:13 Shanna Browning: The danger is life happens. You might have an unexpected car repair or a medical bill, or suddenly you do have to carry a balance for a few months. The twenty four percent APR isn't a yearly rate divided by twelve. It's calculated daily, so the high APR can cause a balance to grow so alarmingly fast. A lower APR provides a crucial safety net for those unexpected moments. It's a feature you hope you never have to use, but you'll be glad to have it if you do.

00:07:45 Daniel Hill: That's a fantastic point. On the savings side, people often get paralyzed by choice. They have some money in a checking account, earning nothing because they're afraid of making the wrong choice for a savings account. What's the flaw there?

00:07:59 Shanna Browning: Well, the flaw is letting the perfect be the enemy of the good. The difference between a 4.8% APY and a 5.0% APY on five thousand is about ten dollars over the course of the year, the difference between a 5.0% APY and the 0% you're earning in a checking account is around two hundred and fifty dollars  . The most important step is simply to get your savings into a high yield account. Any high yield account, you can always move it later if you find a better deal. But the biggest cost is the cost of inaction.

00:08:37 Daniel Hill: So to bring it all home with a final summary, APR is the annual percentage rate. It's the total cost to borrow money, including fees. Your goal is always to find the lowest number possible. APY is the annual percentage yield. It's the total you can earn on your savings, including the power of compounding. Your goal is always to find the highest number possible.

00:09:02 Shanna Browning: One's going to cost you. The other is going to pay you. Master that distinction, and you've mastered a core financial concept that will serve you for the rest of your life.

00:09:12 Daniel Hill: And that brings us to this week's actionable tip.

00:09:21 Shanna Browning: Your action item this week is to become a "Rate Detective" for your own finances and create what we're calling a financial power ratio.

00:09:31 Daniel Hill: So grab a piece of paper or open a note on your phone. First, go online or look at your last statement for your highest interest credit card. Find the APR and write it down. Let's say it's 24.99%.

00:09:44 Shanna Browning: Now we want you to log in to your primary savings account, find the APY and write it down right below the APR. Let's say it's for this example 4.5%.

00:09:56 Daniel Hill: Now we'll do the math. Divide the high APR by the low APY. In this example, 24.99 divided by 4.5 is about 5.5. That means your debt is costing you five and a half times more than your savings is earning you. Seeing that ratio - that debt penalty, in black and white is incredibly powerful.

00:10:22 Shanna Browning: It transforms the idea of paying off debt from a chore into an investment opportunity. Every extra dollar you send to that credit card isn't just paying a bill. It's like getting a guaranteed 24.99% return on your money. You can't find that in the stock market. The ratio gives you the motivation you need to make a plan and attack that high interest debt with everything you've got.

00:10:47 Daniel Hill: Next week, we'll be demystifying one of the most important and misunderstood numbers in your financial life your credit score. We'll break down exactly what goes into it and how you can improve it.

00:11:01 Shanna Browning: To make sure you don't miss it. Please subscribe to Making Sense of Your Cents on Apple Podcasts, Spotify, or wherever you're listening now. And if you have a financial question, send it to us at podcast@fcbtn.com. We'll answer them in our future episodes. Thanks for listening.