One of the most important considerations that you will run into, whether you borrow money or are looking for a return on a cash product, is the interest rate. The interest rate tells you how much you will be charged on a loan, and how much you will earn on a CD or savings account. When you get a loan, you want to pay as little interest as you can, and when you are earning interest, you want it to be as high as possible.
Interest is expressed either as an annual percentage rate (APR) or as an annual percentage yield (APY). You should understand the difference between these two expressions in order to better understand your money and what you’re really being charged when borrowing money.
You will most often see loan offers (including credit cards) use APR to express the base interest rate being charged. This is because the APR looks at the annual rate that comes with the loan, but doesn’t take into account compound interest.
When you see a credit card offer for 13.99% APR, that’s your base rate. However, the interest that you actually end up paying at the end of the year if you carry a balance is going to be a little bit higher because the APR doesn’t include compounding.
This is the rate that takes into account compound interest. This is when you pay interest on your interest. The interest on a loan is figured at regular intervals. Once that interest is determined, it is added to the balance of the loan, and you pay interest on the new total. The formula used for determining APY is as follows:
APY = (1+ (r/n))^n – 1
r = the stated interest rate
n = the number of times compounded
It’s important to note that the stated interest rate should be divided by 100 before completing this formula, so 13.99% would be 0.1399 when plugged into the formula. When you finish the calculation, multiply by 100 to express the answer as a percentage.
As a result of this operation, your APY on the credit card listed above, if the interest is compounded monthly, is actually 14.92%. If your credit card compounds interest daily, the APY is even higher: 15.01%. When you look at the APR of a credit card, you might think that the 13.99% means that you pay $13.99 in interest if you have $100 for the year. That’s what the credit card issuers would like you to have in your mind. However, if your interest is compounded daily, you will pay $15.01 on that $100 by the end of the year.
You can see why credit card issuers offer the APR instead of the APY — the APR is a much more attractive number for borrowers.
At the same time, it is clear why banks advertise their savings accounts and CDs using APY. You end up with higher advertised interest earnings.
The difference between APR and APY is an important distinction to make. You can see what you’re really paying when you use a credit card. This illustration also emphasizes that it is much better to earn interest than to pay it.
When you are paying interest, the money goes right to someone else. You don’t receive new goods or services for your payment. Instead, you simply pay for the ongoing privilege of borrowing the money. When your loan is subject to compound interest, it can actually grow in size over time, since the interest adds to the balance. This is one of the reasons that it’s so important to pay more than the minimum when you are trying to get rid of credit card debt.
Earning interest, though, is a much better proposition. Interest can increase your wealth over time. Compounding interest builds on itself over time, offering you the chance to accelerate your earnings and increase your wealth. It’s important to consider that point as you make your financial plans.
Picture by FreeDigitalPhotos.
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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