Annual Percentage Yield and Annual Percentage Rate
Annual Percentage Yield and Annual Percentage Rate Fin 4440
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This 3 page Class Notes was uploaded by Anna Notetaker on Friday September 16, 2016. The Class Notes belongs to Fin 4440 at Middle Tennessee State University taught by Phil A Seagraves in Fall 2016. Since its upload, it has received 16 views.
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Date Created: 09/16/16
Anna Jacobs Finance 4440 Prof. Philip Seagraves September 13, 2016 APY and APR: Why You Must Understand the Difference First, one must understand the definition of the Annual Percentage Yield (APY) when it comes to fully comprehending the concept. The Annual Percentage Yield is the effective annual rate of return in regards to the effect of the compounding interest. With compounding interest, you are earning interest on previous interest. The formula is the following. APY = (1 + Periodic Rate) ^Periods – 1 Second, one must understand the definition of the Annual Percentage Rate (APR) when it comes to fully understanding the difference between the Annual Percentage Rate and the Annual Percentage Yield. The Annual Percentage Rate is the annual rate charged in regards to the effect of the simple interest in terms of a loan. As a loan, it will provide the individuals the bottomline number that can be compared with other lenders, but it does not take compounding into account. The formula is the following: APR = Periodic Rate x Number of Periods Third, for a little stretching, you can consider the Effective Rate, which is the interest rate that is actually paid on an investment due to the result of compounding over time. So for example, if you put an extra $1,000 down for your mortgage rate, you will be able to save money over time because this can lead to you having a mortgage discount on your interest rate. For example, if you are quoted a par rate at 6.25%, but you want your rate to be 6%, you need to buy down that rate by paying a certain amount, which could be the extra $1,000 down. In the end, as the mortgage compounds, you can potentially save a large amount of money over time if you are able to buy down a low rate on your mortgage. Finally, when understanding the difference between the two Annual Percentages, it begins with the formulas. Annual Percentage Yield is composed of compound interest, while Annual Percentage Rate is composed of simple interest. Now, this may not seem to be a big difference today, but over time, this will affect the individuals greatly in their loan. The following is an example of showing the difference in Annual Percentage Rate and Annual Percentage Yield: 5% APR = 0.416% x 12 5.12% APY = (1 + 0.416%) ^12 1 As a borrower, this difference is something that you must make vital in your knowledge of understanding a loan. The controversy is the fact that often banks do not release the true quote when it comes to individuals deciding on a loan. Banks disguise a loan as having a lower rate, which is known as the Annual Percentage Rate. When it comes to your loan, it is not taking into account the compounding of your loan and is simply stating the bottomline number. Below is stating the difference with compounding over time: APR SemiAnnual Quarterly Monthly Bank Quote: 5% 5.06% 5.09% 5.11% Now when it comes to your savings account at a bank, you want to seek the highest interest rate. This is when the bank will quote you your Annual Percentage Yield since it is the highest possible rate. In the end, you want to focus on the Annual Percentage Yield because this rate will compound over time and will show a great difference in your percentage in regards to a loan. All in all, as a borrower, you want to focus on the Annual Percentage Yield and not the Annual Percentage Rate because the amount of interest will display a significant difference over time. As an individual, this information retaining to loans makes perfect sense to me and it is knowledge I am very thankful to gain. I believe that you can run into individuals in banks and loan institutions that will be honest with you, but when it comes to advertisements, loan interest can be very deceiving. I believe everyone must gain knowledge in regards to the differences in Annual Percentage Rates and Annual Percentage Yields because if you are not aware, you can make a huge mistake when it comes to your quote on a mortgage. This can definitely put you in a mind if you are not aware of the compounding interest of an Annual Percentage Yield. In the end, everyone should care how Annual Percentages work because it is your money that you invest and it is your responsibility to make the best choice in investment as well as keeping yourself aware of your financial status. Works Cited: "Buying Down Your Interest Rate." Mortgage Tips and Industry News. N.p., n.d. Web. 10 Sept. 2016. Interview with my Supervisor, Dwight Baxter Nelson Jr. He is a Certified Residential Appraiser and Senior Residential Appraiser designated by the Appraisal Institute. “Questions & Answers to Help you pass the Real Estate Appraisal Exams”; Jeffrey D. Fisher and Dennis S. Tosh; 2008, ed. 5, Dearborn Financial, pg. 285. “Real Estate Finance Law”; Grant S. Nelson and Dale A. Whitman; 2008, Utah State Construction Registry. Staff, Investopedia. "APR and APY: Why Your Bank Hopes You Can't Tell The Difference."Investopedia. N.p., 29 Dec. 2015. Web. 9 Sept. 2016.