I received an email from a reader who wanted to know what is considered a bad APR, but this is really the wrong question. Instead of focusing on what is a bad or good APR, you should be looking at the APY. Heres why.

First, lets define the Annual Percentage Rate, or APR. The APR of a loan is the annual interest rate that is charged for borrowing. This is often portrayed as the total cost of borrowing money per year (excluding 1 time fees or application costs), rolled into a single number. The idea is that it makes comparing loan offers much easier. The problem is that it is not always accurate.

The heart of the problem is Compounding Interest.

For example, lets consider a simple credit card offer. The offer states that the interest rate (APR) of the credit card is 12%. But once you look at the details, you see that interest is compounded monthly.

This means that were you to carry a balance on the card for a year, the actually interest rate you would end up paying is 12.68%.

This is where APY comes into play.

APY is the Annual Percentage Yield and is the same concept as APR except that it takes into account the effect of compound interest throughout that year.

*** WARNING : MATH AHEAD ***

Heres the formula for computing the APY of a loan:

APY = (1 + periodic rate)^(periods) -1

in the example above, the periodic rate is 1% and the number of periods is 12, since the interest is compounded monthly and there are 12 months in a year. This makes the rate charged per month 1% since the APR is 12% per year (12% / 12 months = 1% per month).

So lets look at the two costs of borrowing the APR vs. the APY

To keep things simple, well assume a balance of $10,000 on the card carried for the year

APR.

Computing the cost using just the APR gives us: $10,000 * .12 = $1,200 per year (or $100 per month).

APY.

Now running the same $10k through the Annual Percentage Yield formula [APY = (1 + periodic rate)^(periods) -1] gives us:
(1 + 0.01)^12 -1 = 12.68% OR 12.68% * $10,000 = $1,268 per year (or $105.66 per month)

So, what does this mean?

If a person has a balance of $10,000 on this credit card for a year, its the difference between what the offer leads him to believe it will cost and the actual cost is $68 per year, or $5.66 per month.

Not a big deal, right?

Maybe not for a $10,000 loan. But when youre considering the cost of a mortgage in the hundreds of thousands things add up pretty quickly.

Note: These are simple examples to illustrate the difference between APR and APY and the importance of knowing which to pay more attention to when applying for a loan.

The other important thing to consider is what is this loan for?

Its impossible to answer the question of whats a good (or bad) APR because theres no context given. Is this a loan for a new car, a credit card or a mortgage?

For credit cards, 16% may be average but if you have excellent credit you may get an offer for 8%. While the 30-year mortgage rate is currently at historic lows of 4%. New car loans may be as low a 0% for certain models, or as high as 10% for borrowers with a poor credit score.

If you take away only 2 things from this article, make it these:

1. APR is relative to your credit score and the type of loan
2. APY is really a better gauge of what youll pay than APR.

In the end, shop around and compare by APY whenever possible.

Further recommended reading: APR and APY: Why Your Bank Hopes You Cant Tell The Difference

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