Borrowing and investing money is a minefield for the average person. Loan officers and financial advisors quote interest rates and expect you to choose between their offerings. Understanding how compounding interest works and the differences between APR and APY can save you from financial mistakes and considerable stress down the road.
About Compound Interest
The saying, “compound interest is the most powerful force in the universe. He who understands it, earns it; he who doesn’t, pays it,” is attributed to Albert Einstein. The essence of this statement means that compounding interest may secure wealth in the future or place borrowers under a mountain of debt.
Simply put, compound interest is the act of earning interest on top of a loan or deposit’s principal amount and the other interest from previous periods. On the flip side, compounding also causes borrowers to pay interest on their loan’s interest. These earnings or liabilities are added to your investment or loan’s initial amount, which is called the principal.
The loans and investment instruments you’ll find on the market apply a compound interest rate to calculate the interest paid out or charged to a borrower. If you are an investor, your goal is to make as much interest as possible on your assets. On the other hand, borrowers strive to reduce the interest on their loans.
Simple interest refers to taking the principal balance of your loan or investment and multiplying it by an overall interest rate. For example, if you take a $1,000 loan and pay a 5% simple annual interest rate on this loan, your added cost is $50 per year. Compound interest calls for multiplying your daily interest rate by the days between payments.
What is Annual Percentage Rate (APR)?
APR determines the amount of interest a bank will charge you when you borrow money. Alternatively, the APR is the amount of interest you earn on an investment. APR doesn’t account for compounding interest that happens within a specific period.
You calculate APR by multiplying the periodic rate by the number of periods in a year. To give an example, if you borrow $1,000 and end up paying back $1,120 over 12 months, your APR is 12%.
What is Annual Percentage Yield (APY)?
APY includes compounding interest and how often compounding happens over 12 months. You will find that APY commonly applies to investment assets and deposit accounts. Money market accounts, savings accounts, and certificates of deposits are likely instruments you will find associated with APY.
Financial institutions and credit unions use your deposits to fund loans they make to other patrons. Banks use APY as an incentive for customers to open accounts and enjoy the compounding rate.
To calculate APY, you take 1+ the periodic rate in decimal form and multiply it by the periods the rate is applied, then subtract 1.
Compound Interest for the Borrower
When taking out a loan, most people’s primary concern is minimizing their interest rate. However, ensuring your cost of borrowing is as low as possible involves discerning between APR and APY. For borrowers that don’t grasp the way compounding interest works, a loan can end up costing more than expected.
One of the tricks lenders use is to quote the loan’s APR. This rate doesn’t account for the compounding that occurs throughout the year in predetermined periods. A loan can compound 2, 4, or 12 times a year, driving up the interest you will end up paying.
A loan that your bank quotes as having a 5% APR, if compounded monthly, will result in a 5.11% APY. The 0.11% difference may not seem like much, but over 30 years, you will end up paying a lot more interest than you initially thought.
Compound Interest for the Lender
Remembering Einstein’s saying, it’s easy to understand why financial institutions quote the higher APYs to potential customers looking to deposit their money. While borrowers seek the lowest interest payments possible, lenders strive to maximize their profits from the financial products they offer. They reinvest profits from interest to offer more loans to their customers.
Advice for Choosing the Best Interest Rates
Financial institutions train their employees to make sales. Their goal is to bring in more profit, not ensure you’re taking out the best loan or maximizing your savings. Therefore, you must do your due diligence and analyze the interest rates quoted.
Look at the frequency that compounding occurs and run a comparison of APYs offered by competitors with equivalent compounding interest rates. Calculate this amount by plugging in the appropriate compounding periods and term lengths. This helps you determine which bank offers the best deal.
Make sure not to confuse APRs and APYs and double-check that the banks you are comparing offer the same maturity periods.
Alternatively, if you’re not good with numbers and are seeking a loan, ask the bank for an amortization schedule. This is a loan payment schedule that lists the payments to be made over time. If the bank does not provide you with one, you can plug the appropriate numbers into a loan amortization calculator and create a payment schedule yourself.
What’s Best for You?
Understanding the differences between the types of interest rates and calculating your cost of borrowing is crucial to your personal finances. The same is true for opening a savings account. Your bottom line can significantly differ given a long compounding period.
Having a grasp on how compounding interest works is essential if you’re considering a mortgage, saving for a new home, planning your retirement, or contemplating how much your credit card debt will end up costing you. It gives you valuable insight and saves you from unpleasant surprises down the road.
You can use a spreadsheet, a pen and paper, or an app to work out how much you stand to gain from your savings or how much a loan will end up costing you. Resist the urge to sign a loan or invest your money without having the complete picture.
The team at Finance is us are committed to helping you make informed financial decisions that benefit you and your loved ones. Contact us today for help with your loans or investments.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.