APR vs. APY… What’s the difference?

By Sabrina Karl

Anyone who has shopped rates – whether for putting money in a CD or savings account, or for borrowing with a mortgage or credit card – has noticed banks and lenders using two acronyms that are almost, but not quite, the same. Sometimes they quote APR, other times APY. What gives?

APR stands for Annual Percentage Rate, and is the basic rate a bank either pays for deposits or charges for a loan. It’s the fixed percentage applied to your balance over the course of the year.

But as many savers and borrowers know, interest grows when it compounds. And that’s where APY comes in. APY stands for Annual Percentage Yield, and it’s the rate you’ll actually yield as a result of compounding.

Mortgages typically compound monthly and credit cards daily. For bank deposits, compounding may occur this often, or may just happen quarterly or semi-annually. The more compounding periods in a year, the bigger the gap between APR and APY.

That’s because interest is charged on previous interest each period. Do it just twice a year and the compounding effect is slight. But if it’s done 12 or even 365 times in a year, compounding will inflate the APY to a noticeably higher number than the original APR.

From there it’s easy to see why mortgage and credit card lenders typically quote the lower APR, while banks soliciting your deposits tend to quote the higher APY.

How much of a difference can it make? Take a mortgage quoted at 4.5 percent APR. After compounding monthly, the rate you’ll actually pay by the end of the year, or the APY, will be 4.59 percent.

Understanding this allows you to ensure you’re comparing apples to apples – APR to APR, or APY to APY, but never mixed – whenever you shop rates.

To escrow or not to escrow

By Sabrina Karl

Although mortgage calculators are infinitely useful for testing how different loan amounts, rates, and terms would impact your payments, the actual amount you’ll owe the bank each month will likely be hundreds of dollars more than what the calculator spits out.

That’s because most mortgage lenders require an escrow account to collect money from you throughout the year for the annual – and often hefty – bills of property tax and homeowner’s insurance (and private mortgage insurance if your loan requires it).

But do you have to escrow? Is saving the money on your own and taking responsibility for making those once-a-year payments an available option? For some borrowers, it is. But even if you can opt out of escrowing, you may not want to.

With some mortgages, you’ll have no choice. All FHA loans require an escrow account, as do most VA loans. Many conventional mortgages require escrowing, too, especially if you make a down payment below 20 percent.

But even when it’s not mandatory, many homeowners opt to escrow because they like the savings discipline it imposes, the predictability of a monthly “all-in” payment, and the convenience of the bank handling their tax and insurance bills.

You may feel confident you can save for these large yearly bills on your own, though. Or maybe you have an irregular income. That’s when a non-escrow mortgage might make sense. You’ll have to ask for it, and it’ll probably cost you a waiver fee or a higher interest rate. But you can offset this with interest earned on your savings during the year.

In the end, the right choice will depend on a combination of factors that include your savings personality, your interest in handling tax and insurance on your own, and how much your lender will charge you for the non-escrow privilege.