Financial Words of the Week: APY, annual interest rate and compound interest
Ever notice that sometimes your interest rate has the letters APY next to it and sometimes you just see a percentage? What do those letters mean? More importantly, how does the difference affect the money you earn in savings and pay on a loan?
First of all, you need to know that compound interest comes from the money you earn on the interest‡ you’ve already earned. This is one of the many reasons you want to get the highest interest rates for your savings/investing and the lowest interest rate for your loans. It differs from simple interest which only earns interest on the principal balance.
Financial institutions should give you two quotes when you are asking about interest rates: the annual interest rate and the Annual Percentage Yield (APY).
The annual interest rate is the yearly rate you earn in an investment or pay on a loan and doesn’t factor in compound interest. The annual interest rate is what the account is currently earning and only involves simple interest.
Example: If your savings account has a balance of $10,000 and an annual interest rate (no compounding) of 1 percent, then here’s how you would calculate your earnings from one year:
$10,000 x 1% = $100 (after one year, your account balance would be $10,100)
Annual Percentage Yield (APY) is the similar to annual interest rate, but it does factor in compounding. This can make a significant difference when it comes to investing and borrowing. APY is what you’ll use when comparing rates for investment/saving options.
Example: If you put the same amount of money into a savings account that utilizes APY (compounding interest of 1 percent), here’s the formula you’d use assuming the interest is compounded twice a year:
$10,000 x (1 + .01/2)2 = $10,100.25 (balance after one year)
While the above examples show insignificant differences – did we really take the time to explain all this for a 25 cent difference? – the larger your interest rates and deposit balances are, the more impact APY vs. annual interest rate will make. Remember, compound interest is your friend when you’re saving or investing and your foe when you’re taking out a loan or using a credit card.
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UMB Financial Corporation (Nasdaq: UMBF) is a financial services holding company headquartered in Kansas City, Mo., offering complete banking, payment solutions, asset servicing and institutional investment management to customers. UMB operates banking and wealth management centers throughout Missouri, Illinois, Colorado, Kansas, Oklahoma, Nebraska and Arizona. It also has a loan production office in Texas. Subsidiaries of the holding company include mutual fund and alternative investment services groups, single-purpose companies that deal with brokerage services and insurance, and a registered investment advisor that manages the company's proprietary mutual funds and investment advisory accounts for institutional customers.
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