Credit cards advertise an APR, but because interest compounds daily, the true annual cost you pay is a slightly higher number called the effective annual rate, or APY. The gap is small on any single day but real over a year of carrying a balance. Knowing the difference helps you compare the genuine cost of borrowing.
What APR means
APR stands for annual percentage rate, and for credit cards it is a simple nominal rate: the daily periodic rate multiplied by 365. It does not, by itself, account for the effect of compounding within the year. That is why the APR is sometimes called a nominal rate. It is the number issuers must disclose and the one you see on offers and statements.
What APY means
APY, the annual percentage yield, or equivalently the effective annual rate, folds in compounding. Because card interest is added to your balance daily and then accrues more interest, the amount you actually pay over a year is more than the flat APR implies. APY is the honest, all-in annual rate once that daily compounding is counted. Banks quote APY on savings for the same reason: it reflects compounding.
The math behind the gap
To convert, you compound the daily rate over 365 days: the effective rate equals one plus APR divided by 365, raised to the 365th power, minus one. A 20 percent APR works out to about 22.1 percent once compounded daily. A 25 percent APR becomes roughly 28.4 percent. The higher the APR, the wider the gap between the sticker rate and the real cost.
Why it matters for you
If you always pay your statement balance in full, neither number costs you anything, because the grace period keeps purchase interest at zero. The distinction only bites when you revolve a balance, and then the APY is what you truly pay. When comparing cards or a card against another loan, remember the card's effective cost is a bit above its stated APR. This is one more reason revolving high-APR debt is so damaging.
A card with a 24.99 percent APR compounds to an effective rate of roughly 28.4 percent. On a 6,000 dollar balance carried for a year, that difference between nominal and effective adds up to a couple hundred dollars of extra interest you might not have expected from the APR alone.
Key takeaways
- APR is a nominal rate; APY, or effective annual rate, includes compounding.
- Card interest compounds daily, so your real annual cost exceeds the stated APR.
- A 20 percent APR works out to about 22.1 percent effective once compounded daily.
- If you pay in full every month, the grace period means you owe no interest either way.
- The higher the APR, the larger the gap between APR and APY.
Common mistakes
- Comparing a card's APR directly against a savings account's APY as if they used the same basis.
- Assuming the APR is the maximum you can pay when compounding pushes the real cost higher.
FAQ
Do card issuers advertise APY?
No. By law they disclose APR for borrowing, while APY is used for deposit accounts. You have to compute the effective rate yourself to see the compounded cost.
Does compounding matter if I pay in full?
No. Paying your full statement balance each month keeps purchase interest at zero, so the gap between APR and APY never touches you.