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Several years ago our government took a survey about finances. They asked people what one thing they most wanted explained to them.
 Their answer was:
What’s APR?
APR means Annual Percentage Rate. It has to do with the amount of interest that is charged to you if you borrow, or paid out to you on your investment or savings.
By law you always have to be told your APR when you take out a loan or open a savings account. When you take out a mortgage, the APR includes fees and other charges.
Simple interest is easy to understand.  Let’s say the APR is 10% on your savings and you have $10,000. That means after one year the bank will pay you $1,000 in interest
($10,000 x .10), and your savings will grow to $11,000 ($10,000 + $1,000 in
interest) after one year.
Compound interest is harder to figure out. Compound interest is figured more than once a year, |
perhap s quarterly, monthly or even daily. Compound interest makes a tremendous difference in the amount of interest earned or paid out.
Let’s take our $10,000 savings, still at a 10% APR, but this time we will compound the interest twice a year. After six months, our $10,000 has earned $500 ($1,000/2) or half a year’s interest. Now when interest is compounded, it means we’re going to earn interest on our interest!
That $500 of interest will earn 10% APR too, or $50 a year. Since half the year is over, it’ll be half of that, or $25.
So, at the end of the year, we’ll have $25 more in interest (or $1,025) than if we had a simple 10% interest account. We now have $11,025 at the end of the year with compound interest, instead of just $11,000 with simple interest. The APR (or Annual Percentage Rate) does not include compounding.  The APY or Annual Percentage Yield is the rate actually earned or paid in a year. In the example above, the APY is 10.025% because of compounding. | |
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 Let's
consider different compounding periods. The above example demonstrated what would happen if interest compounded semi-annually (twice a year). Let's see what happens when interest is compounded more frequently. In each example, we have $10,000 in savings earning 10% interest.
| Quarterly |
$10,000 |
$1,038 |
$11,038 |
| Monthly |
$10,000 |
$1,047 |
$11,047 |
| Daily |
$10,000 |
$1,051 |
$11,051 |
If
interest is compounded on our $10,000 at 10% APR quarterly (four times a year), we’ll come out with $11,038 ($10,000 + $1,038 in interest). Monthly compound interest earns us even more. Our $10,000 becomes $11,047 at the end of a year ($10,000 + $1,047 in interest). If we compound it daily, we get $11,051 ($10,000 + $1,051 in interest).
The math formula for
 compounding interest is this:
P = C(1 + r/n) nt
KEY: P = future value; C = initial deposit; r = interest rate (expressed as a fraction: e.g. 0.06); n = # of times per year interest in compounded; and t = number of years invested |
 Because this formula is difficult for just about anyone, most people just plug numbers into an automatic calculator for compound interest such as the one in this
link.
If you are earning compound interest, you will earn money at a much faster rate than simple interest. If you have two
savings certificates that both pay 8% with one compounding daily and the other compounding monthly, then you pick the one with the interest compounding daily.
But what if you have two
certificates and one pays 8% compounded quarterly, and another pays 7.3% compounded daily?  How can you compare them if they have different interest rates and compounding periods?
This is where APY comes in real handy. Look at the Annual Percentage Yield (APY)
and pick the APY that’s highest.
For more info about interest, click here.
See what you learned.
Check out
"Pay Attention to Paying Interest" | |         |