Beginner's Guide to Compounding Interest

Compounding interest simply means interest can be earned on interest. With simple interest, you will know from the beginning of a financial agreement just how much can be earned or owed from the contract. With compounding interest, the ultimate reward or cost will depend on how much interest has accumulated and compounded during the life of the agreement. It is important to understand the affect of compounding interest on loans and investments.

Compounding Interest Explained

As an investor, you will want to earn as much as possible. For example, you invest $100 in a CD at a rate of 5 percent calculated quarterly for 2 years. The interest compounds each quarter. The $0.41 you made in the first quarter will be added to the principal investment. Therefore, for the second quarter, your principal sum will be $100.41, and your earnings will be a fraction of a cent higher in the following quarter. All told, you will earn $10.45 on the investment over two years. This may seem small, but it is important to remember the affect of compounding interest can be huge with large sums of money.

Annual Percentage Rate vs. Annual Percentage Yield

Lenders and financial investment firms quote two separate figures for interest: APR and APY. APR is a simple calculation of interest using the formula:

APR= Periodic Rate (interest) X Number of Periods in a Year

With APY, the formula is more complicated to account for the fact that interest will not be charged on the principal alone. Instead, the interest will be calculated each period based on the total amount of money in the account using this formula:

APY= 1+ Periodic Rate (interest) ^ Number of Periods in a Year - 1

APY is always higher than APR. On the base level, the two may be using the same factors to determine a measure of cost or profit. In the end, though, if your loan or investment uses compounding interest, the APY is a more accurate measure.

Lenders Quote APR

When you are shopping for a loan, such as a mortgage or car loan, your lender may quote you interest in terms of APR. Since APR is lower than APY in this calculation, the lender is making it seem as if you have a lower cost than you actually will have once the affect of compounding has been accounted for. It is entirely legal to quote APR in a contract or an advertisement. Look for a statement of the number of periods in which interest will compound in a year to gain a more accurate picture of APY.

Sales People Quote APY

When a sales person from a bank or financial institution is attempting to sell you a CD or other instrument for investment, you will likely hear the individual quote interest in terms of APY. APY sounds higher than APR, so this makes the investment appear more attractive. Again, this is lawful and accurate, but it may throw off your estimates and calculations. If you are considering two investment options, make sure both are listed according to the same formula. Otherwise you will not have an equal comparison.

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