Annual Percentage Rate vs Annual Percentage Yield: What's the Difference?
When you're looking at investment options for your IRA account, the choices can be overwhelming. There are thousands of choices available, and trying to decipher the financial information given for each type of investment product can be confusing. Often, one of the first questions that many people have when they are reading through the information that comes with their account or even trying to decide where to set up an account is 'What is the difference between APR and APY?'
The APR and APY are usually one of the first things that is printed on the front page of an investment report or prospectus. These reports describe the fund or investment product to a potential customer. While both of these figures are meant to show the previous gains that the investment product has made, there are some key differences between them.
Annual Percentage Rate
APR, otherwise known as the annual percentage rate, is defined as the actual rate an investment produce returns during a one year period of time. For example, if an initial investment of $10,000 is made in an investment product with an annual percentage rate of 12%, the interest that accumulates over one year would be $1,200.
While this seems like a fairly simple calculation, there is one big problem. Many investment products accumulate interest and/or dividends every day, week, or month instead of once a year. In these cases, the actual interest rate or returns that are paid annually can be more or less than the stated APR.
Annual Percentage Yield
APY, otherwise known as the annual percentage yield, is the actual amount of money that the investment earns expressed as a percentage. This means that APY takes into account the daily, weekly, or sometimes hourly fluctuations that an investment will have. In nearly every case, these numbers will be different. In the case of investments with a guaranteed pay out, such as money market accounts or CDs, the APY will be higher than the APR. This is because interest is earned on the money that the original investment has already earned. This process, known as compounding, is a good reason to leave money in an investment.
On the other hand, investment products that do not guarantee their earnings, such as stocks and mutual funds can lose value from time to time. In some cases, this means that an APY can be less than an APR. In some cases, the fund could lose enough money over the course of a year that the APR and APY could be negative numbers.
Keep in mind that while it is required for most investment products to post their APY and APR, it is not a guarantee of future performance. This means that just because a particular investment product did well in the past year, it may or may not earn a similar amount of money this year.