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What do they mean and what is the difference?

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The financial world has many abbreviations and terms that sound confusing. If you don't know the jargon related to personal finances, your head may start spinning when you read your bank statements and credit cards.

APR and APY are two of the most common acronyms used in the financial sector, and many people have no idea what the letters mean or what the terms mean. In this article, we are going to break down everything you need to know about APR and APY.

APR explained

APR is the acronym for "Annual percentage rate." This term describes the annual interest you pay on any loan from banks or lenders. The legislation requires all financial lenders to explain the terms and conditions of APR in any product they sell to consumers. By showing the APR, lenders allow you to compare rates between lenders, ensuring that you get the best deal when lending money.

Visit the website of any financial institution that facilitates the loans, and most of them will have an APR calculator on the site. This calculator allows you to know the total cost of the credit issued, as well as the amount of interest you pay on the account and your monthly installments. Most calculators allow you to play with the monthly amount, showing how much you can save if your payment increases.

APR mechanics

All lenders calculate the annual percentage rate based on industry regulations established by the financial authorities and the financial services board. This regulation ensures that financial institutions do not participate in predatory financing, where they take advantage of people seeking to borrow money.

The regulations stipulate how lenders charge interest to your account, and any other fees involved in providing credit to consumers. The laws make it easy for anyone to calculate the APR on their credit lines and compare them with other products offered in the market.

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Let's look at an example of how to calculate APR on loans and credit cards.

If you sign a contract with a bank for a personal credit line of $ 1,000, with an annual percentage rate of 12 percent, the interest on the account will cost you $ 120. This figure means you pay nothing for the principle you owe ; In other words, it does not make loan payments. In reality, you will make monthly payments of the outstanding debt. Therefore, as you reduce outstanding capital, you will pay less interest.

Lenders add APR to outstanding debt each month. To calculate your monthly interest costs, divide the APR by 12. Therefore, the monthly APR owed to the principal is 1 percent, or $ 10. It is important to keep in mind that the amount of interest you pay on the outstanding amount It depends on the duration of your payment schedule. Therefore, if you had to take a 2-year loan, the monthly repayment would be less, but you will pay more interest.

Representative or typical APR

We have discussed that APR is the interest rate you pay on any line of credit with a lender. When you open a line of credit, you may notice that the lender announces a typical or representative APR in the payment terms and conditions.

Representative APR is what lenders use when they advertise credit lines, such as personal loans and credit cards. However, when the time comes to sign the contracts, the lender can change the APR. Lenders base their APR on a variety of factors, such as your credit score and history with the lender.

Therefore, you may end up paying more for your credit than the advertised rate. While you may think that this is a predatory lending strategy, it is an industry-wide phenomenon that all lenders practice. If you have a credit score that is in the 800s, then you can negotiate with your lender to secure an APR that is less than 12 percent in our example.

Because you have a good credit score, the lender is likely to offer you a point or two less than the representative APR rate. However, if you have a weak credit score in the 600s, then the lender may choose to increase your APR to 17 percent. This strategy encourages you to only use the installation if necessary. Lenders offer a higher annual percentage rate to people with weak credit scores to reduce their risk in the agreement.

The representative APR announced by the lender "represents" typical rate charges to 51 percent of consumers who hire a designated line of credit. This term means that the other 49 percent will pay less or more than the representative APR figure in the ad.

It is for this reason that it is vital that you verify your credit score and credit report before requesting any line of credit. When the lender calculates your APR, it issues a "hard inquiry" on your credit report, resulting in a temporary drop in your credit score.

Many people make the mistake of filling out credit applications with numerous companies. However, the consumer does not realize that each time the lender takes out his credit report, it results in more points deducted from his credit score and a higher APR at ease.

Instead of requesting five or six different facilities, find out your credit score with the credit bureaus. Visit the lender and ask them what an APR would be for your credit score and loan profile, without telling them to verify your credit report.

While no lender will commit to an APR without first checking your credit report, they can provide you with an approximate figure for your investigation. Using this strategy helps you preserve your credit score by reducing difficult queries in your credit report. After finding a lender that offers the lowest APR based on your research, begin your application process.

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What constitutes a good APR?

As mentioned earlier, the APR you receive on credit lines depends primarily on the status of your credit score and your transaction history with the lender. If you see a lender announcing "0 percent introductory offers," then you should not take this as the APR they will offer you at the facility.

Lenders use this advertising strategy to convince consumers to apply for credit. The introductory offer of 0 percent means that you only pay 0 percent on the installation during a specific period, usually between five and 10 billing cycles. After the introductory period ends, you must pay the specified APR set by the lender based on your credit score.

Most lenders offer an introductory rate of 0 percent and beat their clients with a higher annual percentage rate after the introductory period expires. The average APR after the introductory period ends will generally be between 18 and 20 percent. As a guideline, any line of credit with an annual percentage rate below 18 percent is "cheap," while the 20 percent mark is on the high side.

Consumers with low credit scores can receive an annual percentage rate of between 24 and 50 percent. If you speak with your financial advisor, you are likely to be told to avoid hiring any line of credit with an annual percentage rate greater than 24 percent. In these cases, the cost of the debt is not worth the convenience of the credit, and it can result in you paying much more than you can pay for your monthly reimbursement at the facility.

Some lenders offer consumers "secured credit cards" if they have no credit score or bad credit. However, these cards generally come with scandalous APRs that exceed 24 percent, as well as high annual account fees, which you must pay in advance.

Avoid APR

While lenders charge a high annual percentage rate on credit cards, there is a way to avoid paying interest on their facilities. Most lenders offer a moratorium period if you pay your outstanding balance in less than 55 days. This period varies from lender to lender, and not everyone will offer a moratorium period on interest.

However, if you are a responsible lender and pay your credit card in full at the end of each month, then you will never have to pay any interest on your outstanding balance. This interest-free moratorium allows you to benefit from your spending and payment habits by improving your credit score.

Most credit card companies also offer incentives and rewards for paying your balance in advance. Frequent flyer miles and other reward programs offer you money back on a wide range of goods and services as a reward for using your credit responsibly.

Before enrolling in any line of credit, especially credit cards, ask the lender about APR, interest moratorium and rewards programs.

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APY explained

APY refers to an acronym for "annual percentage yield." APY is a useful tool to calculate the interest you earn on your money. Most lenders offer consumers an interest rate quote when opening a savings or investment facility with their institution. However, this figure is not an accurate measure of the possible returns on your funds.

APY offers a more complete annual interest calculation because it takes into account the effect of compound interest on your funds during the year. APY represents the interest you earn on deposits, as well as the interest earned on interest accrued on your investment. It is for this reason that it is better to choose an investment facility that offers a higher APY.

When depositing funds in a CD, money market or savings accounts, the financial institution will pay interest on your money. The APY rate differs from lender to lender, as well as among financial products. Some institutions may also offer APY interest on deposits over a specific amount, such as $ 2,000. Therefore, it is worthwhile to shop around for the best APY available before allocating your funds to any investment.

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Why is APY the benchmark for your investment or savings account?

APY is the benchmark for selecting a savings or investment account, as it uses compound interest to give you an accurate picture of what you can expect in terms of interest accrued on your investment for a year.

Compound interest is one of the secrets of wealth creation because it allows you to earn interest on interest accrued on your investment. The capitalization effect starts small, but if you deposit your money in a long-term investment account, such as for more than 10 to 20 years, you will reach a turning point where the annual accumulated interest becomes exponential, dramatically increasing the amount of money you earn on your savings and investments.

For example; If you deposit $ 1,000 in a CD or savings account that offers an annual interest rate of 5 percent, then you will earn an additional $ 50 during the year. At the end of the year, you have $ 1050 in your investment account. However, if the lender calculates and pays interest on your savings every month, which is usually the case, then you will have $ 1,051.16 at the end of the year. In this example, you earn an APY of more than the 5 percent rate quoted.

While the additional $ 1.16 may not seem like much, you can imagine the difference it makes if your investment continues to increase each month and if you deposit more than $ 1,000 in this example.

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Key conclusions: the difference between APR and APY

At this point, you should have an idea of ​​the difference between APR and APY. APR describes the amount of interest a lender charges you on a line of credit. The APR also varies from lender to lender, and between financial products.

APY describes the interest that a financial institution pays for the money it deposits in a financial vehicle, such as an investment or savings account. APY also differs between products and financial institutions, and should not be confused with the quotation of the interest rate offered.

APY allows you to benefit from the effects of compound interest on your deposit, increasing your wealth. APR describes the amount of money the lender removes for the privilege of lending money.

When it comes to finding the best annual percentage rate, always look for the lowest figure offered by the lender, and make sure they provide you with the typical annual percentage rate, and not the representative annual percentage rate.

When you get the best APY, look for the highest figure offered by financial institutions and don't confuse it with the average annual interest rate quoted.

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