Benjamin Franklin and Albert Einstein have both been quoted as fans of compound interest. While compounding interest might not be E=MC2 or the Declaration of Independence, it will talk to an understanding of how math can impact our look at the universe.
This is particularly true when you're coping with two commonly seen but often misunderstood abbreviations, Apr (APR) and Annual Percentage Yield (APY). While APR and APY seem the same, banks, lending institutions, along with other lenders rely on them in different ways once they lend you cash or request you to deposit cash with them.
Compound Interest: What exactly is it And How Does It Affect APR and APY?
Compound interest refers to interest that's earned on previously earned interest, that is then put into the initial balance of the loan. In the simplest form it could work like this:
Put $100 into a pursuit bearing account with a 4% APR. At the end of your first year, you'll have earned 4% interest on $100 ($4) bringing the entire to $104. The second year you will earn 4% on the $104 ($4.16) for any total of $108.16. So each year you retain the cash in the account you get some extra. With sufficient money and sufficient time, it may accumulate.
Most loans and investments use some form of compound interest.
When you're charged money to gain access to, that quantity is generally measured using an APR. While your APR doesn't take compounding interest into consideration when promoting your rate, it will come up should you carry a balance over time.
When a lender tells you just how much return you can expect to receive with an investment, it's measured using an APY. Lenders will often promote APY using compound interest, which could boost potential earnings and the potential APR.
What is APR (Annual Percentage Rate)?
APR, sometimes known as the Effective Annual Rate (EAR) or Effective Interest Rate (EIR), is really a measure of the all inclusive costs to borrow money from a lender. APR includes both the interest on money you're borrowing and the lender fees, closing costs and insurance that you are prone to pay.
APR usually applies to several credit scenarios, including these:
- Credit card
- Home mortgage loan
- Personal loan
- Student loan
- Personal or business line of credit
- Home equity loan or home equity credit line (HELOC)
Here's why APR can also add up so quickly. It is because APR is determined by multiplying the periodic interest rate by the quantity of periods where the periodic rates are applied.
While APR measures interest inside a one-year period, the amount of periods within that year can range from monthly (12) to quarterly (4) to semi-annually (2) to annually (1).
APR = Periodic Rate x Number of Periods in a Year
So for instance, if you have a loan that charges 1% interest every month your APR would be 12% for the year.
That doesn't seem too bad, but don't forget that you're charged interest if you don't pay off balance entirely every month. Credit card companies actually hope that you won't do this, so as your balance goes up, you're paying interest each month based on your present balance.
What is APY (Annual Percentage Yield)?
So if the APR may be the cost to borrow, APY may be the return you can make when you put money into an interest-bearing deposit account like a:
- Savings account
- Money market account or other high yield savings account
- Certificate of deposit (CD) or other investment account
Here's the formula for calculating APY.
APY = (1 + r/n)n – 1.
Where r equals the interest rate and n equals the number of periods.
The math receives a little complicated, but essentially if you multiply 12% alone when you are a 12% return within the newbie (e.g., compounded once every year – one period.)
If you multiply 1% times itself 12 times you get a 12.68% return within the newbie (e.g., compounded once each month – 12 periods). It might not seem like much, but that .68% can add up when you are talking about 1000s of dollars over 10 – 30 years.
APR vs. APY: What's best?
With APR and APY, it's not about which is better – it's the way they are applied. They're different ways to measure how much money you may pay to borrow (APR) or how much you can earn whenever you invest (APY).
That said, it's wise to understand how lenders use APR and APY so that you can learn how to pay less to borrow or have more back when you invest.
How lenders use APR
If you are looking for a loan or a charge card, a lesser APR results in it will cost you less to gain access to, both in interest and fees.
Lenders will advertise a minimal APR being an appealing method for saving you money on the short-term loan. In the end, an APR of 3% – 6% on a mortgage, 4% APR on the education loan or even 14% APR on the charge card doesn't seem that bad. But watch what goes on when compound interest is applied.
- Credit card interest: If you have a credit card having a $2,000 balance along with a 14% APR making a payment of $80 every month to cover the total amount, it would get you 2 1/2 years to pay off the balance and price you $378.39 or 16% of the original loan balance. That's assuming you don't make any extra purchases with the card which no additional fees are put into balance.
That might not appear to be much on this small charge card balance, so short term, the lenders are right. But a minimal ARP on the larger balance on the longer period of time can be more daunting, as with mortgages and student loans.
- Mortgage interest: A $100,000 fixed-rate 30-year mortgage with a 3% APR would cost $51,777 over the lifetime of the loan or 51% of the original loan's value.
- Student loan interest: A $10,000 student loan with a 10-year term and 4% APR would cost $2,149.42 in interest within the lifetime of the loan or 21% of the original loan's value.
So, given that information, you can see how ARP works over time. But it's also good to understand that if your loan has a higher ARP, it may be cheaper if it's temporary, or if you pay it off quickly, because it has a shorter period to accrue interest and fees.
Regardless of the ARP, paying down any debt in a shorter time period, instead of longer, is an excellent method to reduce your price of borrowing money.
How lenders use APY
Lenders discuss APY the opposite way. A bank will advertise their APY to appear as robust as possible by maximizing the possibility compound interest.
So when you compare potential offers, you'll want to see how often the interest compounds for different types of savings or investment accounts.
For example, should you invest $10,000 over 10 years in a 12% APR that compounds annually, you'd earn $31,058.48. But when that very same APR compounds monthly, you'd earn $33,003.87 for any difference of $1,945.39 more.
Tips To get the most from Your APR and APY
The answer to obtaining the best possible APR or APY would be to browse the small print in your agreement and employ it to make a level comparison of competing offers. This is what to understand when reviewing the fine print.
Know the frequency
For APR: Remember that with APR for charge cards, the interest you have to pay will compound monthly, which could quickly cause your balance to increase.
For APY: Even if the APY to have an interest-bearing account may seem exactly the same, the eye you receive can differ based on if the interest compounds weekly, monthly, quarterly or annually.
Know the fees
For APR: Your APR often includes a lot more than your interest. Additionally, it includes the fees you're charged upfront or on a monthly or annual basis. The difference can add hundreds or thousands of dollars to the total price of your loan.
For APY: A thing of caution: a checking account may advertise a certain interest rate, however, if the account charges a regular monthly or annual fee, that may actually lower the APY.
Know the variables
For APR: While some loans like mortgages have a fixed APR, other loans can have a variable APR that shifts down or up in line with the relation to your loan and variations in interest rates. For instance, some charge cards and loans offer low introductory APRs that can spike following the introductory period to something much harder to afford.
For APY: Meanwhile, lenders may not offer APY for the full balance of the loan. For instance, in case your lender offers a 1% APY, it may only be good for balances of up to $25,000. After that, every additional dollar may only earn .5% APY.
Or to be eligible for a a certain APY, you may want to meet certain conditions like maintaining the absolute minimum account balance or creating a certain number of monthly transactions to qualify for the advertised APY.
Know your credit
When you apply for a loan, lenders will base the annual percentage rate they offer you on your credit rating. The better your credit, the lower your APR.
The Devil Is in the Details
When all is said and done, APR and APY can help you borrow and spend less effectively. The secret would be to know how much you're really paying or earning when you begin to work with a lender or credit card company.
