Overwhelming terminology often makes borrowing or lending money for the first time intimidating. This is especially true when comparing types of interest, as several easily confused terms sound similar but have meaningful differences. Luckily, it’s not as complicated as it might seem.
How Interest Works
Interest is the cost of borrowing money. Doing so can be expensive because it requires a financial contribution to establish a personal stake and because of the concept of the “time value of money.” This widely-held economic principle states that holding onto money is worth something more than the face value of the money itself due to the money’s potential to earn (to grow through investment) over time.
When someone borrows money, it’s not only the “principal,” or the original loan, that must be paid back. To incentivize the lender to lend in the first place, it’s also the cost of that money’s growth potential that must be repaid—the interest—making the loan, in essence, an investment in the borrower. Furthermore, interest can compensate the lender for the risk that a loan might not be paid back in full. Generally, the higher the perceived risk of default (or the prospect of not getting their money back) to the lender, the higher the interest charged.
Interest does not always flow from an individual to an institution. In the case of a savings account, for example, an account holder is technically lending money to their bank by allowing the bank to hold it—and due to the time value of money, this is worth something to the bank. A savings account doesn’t pay much interest, but the bank will nonetheless pay, proportional to the amount “lent,” for the privilege of having access to the client’s money.
Interest Rates
An interest rate is usually expressed as a percentage of the principal and depending on the type of loan, it may be subject to fluctuation over time. As with the pricing of most other types of services, the borrower looks for as low an interest rate as possible, while the lender must determine how to profit from the service provided while offering competitive pricing.
Interest rates can vary widely, even within the same category of loan, depending on circumstances. Some loans have specific types of payments, all with their own terminology. Interest rates convey a specific, quantifiable price for borrowing money that can be applied to loans of all types and sizes.
APR
An annual percentage rate describes the interest rate a borrower pays on a yearly time frame, even though the loan’s pay periods are likely much more frequent. APR speaks specifically to the cost of borrowing money, whether for a mortgage, a car or a credit card. APR represents a loan’s periodic rate (the interest rate given for a specific period, such as a day or a month) multiplied by the number of periods in a year. This makes it a useful point of comparison, as the annualization provides a common reference for all sorts of loans with different periods and terms.
One important distinction about APR is it does not account for compound interest—interest that is calculated off the principal plus accumulated interest from previous periods, rather than just the principal. Because of its usefulness for comparison, APR is still often employed to describe loans with compound interest—such as credit cards—even though it will undershoot the actual cost to the borrower. This is why it’s sometimes called a “nominal APR.”
APY
The annual percentage yield, also known as “earned annual interest” (EAR), is another way to express an interest rate. Banks and investors mostly use it to describe the rate of return to the client when the client is the one “lending.” For example, in the case of a savings account, a certificate of deposit, individual retirement account and so on. It tells the lender how much money their money is making in interest.
Unlike APRs, APYs account for compound interest, and as such they express an investment’s true yield to the lender. Unlike APRs, though, they don’t account for any ancillary fees. APYs often describe a rate with a higher figure than a nominal rate; the higher the frequency of compounding, the greater the difference between the two. This is part of why APYs and APRs have come to find such different uses even though they represent similar concepts.
When lending, a financial institution will advertise APR because, without the added value of compound interest, the interest rate appears lower and more desirable to the borrower. When that same institution wants to attract investors, it advertises APY, which will look like a higher number, representing a more attractive interest rate to a potential lender.
Read more. Best 0% APR Credit Cards of 2025
Bottom Line
It doesn’t matter whether you are taking out a mortgage, applying for a credit card or setting up a savings account—it’s important to understand interest rates and the common representations. APRs and APYs offer vital insight into the loans and investments they describe, though it’s necessary to be wary of their limitations.
While APYs are often a more realistic indicator of interest owed, APRs can be more illuminating of the other costs associated with borrowing besides an interest rate. With an understanding of these differences, consumers can consider themselves armed with the ability to draw logical conclusions from these common ways of describing interest.
