Final answer:
APR is the annual rate charged for borrowing or earned from an investment without compounding, while APY includes the effects of compound interest and provides a more accurate figure over time. Compound interest, which is interest on the principal and the accumulated interest, increases the APY compared to the APR.
Step-by-step explanation:
APR (Annual Percentage Rate) and APY (Annual Percentage Yield) are concepts that represent the interest rates associated with saving or borrowing money. APR is a simpler measure of the cost of a loan as it does not take into account the effects of compound interest. It is basically the annual rate charged for borrowing or earned through an investment without compounding. In contrast, APY does take into account the effects of compound interest, providing a more accurate picture of what borrowers will pay or savers will earn over time. Compound interest plays a pivotal role in the difference between APR and APY. Compound interest is the calculation of interest on both the initial principal and the accumulated interest from previous periods. This could be annually, monthly, or even daily. The more frequently the interest is compounded, the higher the APY will be in comparison to the APR. Therefore, when evaluating investment options or loans, it's crucial to understand not just the quoted interest rate (APR), but also how frequently that interest will compound, which is represented by the APY.