A few weeks ago I mentioned to a friend that she should get a new savings account that pays more interest. She asked me how much more she could be earning. I told her that my bank pays 1.30%. Hers only paid 0.25%! In other words, she would earn 65 dollars every month on her balance of $5000. Not bad…
Except for the fact that I was wrong.
Unfortunately, I was thinking of simple interest. It’s simple because all you do is take the balance (in this case $5000) and multiply it by the interest rate (1.30%). I also thought that my bank paid me 1.30% every month.
Unfortunately, in the banking world things aren’t always as they seem.
Instead of simple interest, banks typically use what’s called compound interest. It’s called this because the money you earn is added back into your account. Basically, compounding is the process of interest earning interest. The interest is typically compounded (added to the account) every month. (This is a good thing when you’re saving money by the way.)
Things get sticky however when advertising gets in the picture. When a bank advertises the interest rate for a savings account, they give you what’s called the APY. This stands for annual percentage yield. This means that you earn the interest rate over the course of the entire year.
So you will in fact earn 1.30% or 65 dollars, but it’s going to take you the whole year (annual=year) to do it. Each month, you’ll earn 1/12 of 1.30%. So instead of earning 65 dollars each month, the bank will pay something like 5 dollars and 42 cents. It’s still free money of course, but it’s not as simple as you’d first believe.
I’ve created this simple table to show you how much you’d have each month.
Things change a bit when you borrow money. Instead of giving you the APY, banks give you the APR or Annual Percentage Rate.
Why do banks use two different terms and calculations? Because they want to make their product look more appealing.
Let’s look at how credit card companies use APR to make you think you’re getting a better deal.
Let’s say you charge $2000 on a credit card that charges a 23% APR. You might think that if you don’t make a single payment all year, that at the end of the year, you would owe $2460. (2000*0.23=460). But compounding interest tells us this isn’t the case.
APR does not take into account compounding. What does this mean? It means that a credit card with an APR of 23% has an APY of 25.58. So from the above example where $2000 was charged, the interest charges would bring the total to $2576.05. That’s an extra $116.05! Plus, remember that the interest is compounding every month.
In the end, it’s up to you to know what you’re getting into. Obviously, the banks don’t make this super easy. But with a little research, you can figure out what’s really going on behind the scenes.
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The difference between yield and rate are actually one of perspective. You earn a yield, and pay a rate. Both of these terms can either be stated as nominal (the annualized monthly rate), or effective (the rate paid factoring in the compounding effect). It’s actually the 1991 truth in savings act that forces savings accounts to use the effective APY, which was to allow people to easily compare products with different compounding schedules.
For some odd reason, the Truth in Lending Act went the opposite way, and required that APRs in the US be stated as nominal rates, plus fees.
If you or any of your readers are considering attending college out-of-country, you should know that the meanings of these terms vary significantly between jurisdictions.