Say âinterest rateâ and the next words that come to mind are inevitably âloansâ or âcredit cardsâ. Fortunately, âinterest rateâ doesn’t always have to refer to âowing more money on principalâ.
Modify the terms slightly and you get âinterest incomeâ. Here ! It equates to a much happier (and more profitable) thought.
Interest income has two interrelated terms: APR and APY. The common acronym is APR, which refers to annual percentage rate. A slightly less well-known term is APY, or annual percentage return. They both calculate interest income, but one calculates annually and the other can calculate daily or monthly, depending on the financial institution.
APY vs APR
APR calculates interest for investments. This means that if you have $ 10,000 in an interest-earning account for the entire year and your APR is 1.25%, you will have earned interest of $ 125 for the year. At the end of the year, you will have $ 10,125 in your account after interest is applied.
APY is a slightly more complicated calculation for calculating interest earned, but it is more profitable for the account holder. APY is more profitable because of the compound interest.
|Initial investment||APY||Standard APR|
|$ 100,000||$ 101,257.82||$ 101,257.19||$ 101,255.87||$ 101,250.00||$ 101,250.00|
- Equation: A = P (1 + r / n) ^ nt
- Variables: A = amount of investment earned, P = amount of initial investment, r = annual interest rate, n = number of times interest is compounded over a period of one year, t = number of ‘years for investment
- Daily calculation: $ 101,257.82 = $ 100,000.00 (1 + (0.0125 / 365)) ^ (365 * 1)
- Monthly calculation: $ 101,257.19 = $ 100,000.00 (1 + (0.0125 / 12)) ^ (12 * 1)
- Quarterly calculation: $ 101,255.87 = $ 100,000.00 (1 + (0.0125 / 4)) ^ (4 * 1)
- Annual calculation or APR: $ 101,250.00 = $ 100,000.00 (1 + (0.0125 / 1)) ^ (1 * 1)
To see what your account balance will earn, take your initial investment, multiply it by 1, plus the interest rate divided by the number of compounding periods. Take the total and apply it to the power of the number of compounding periods multiplied by the years of investment.
As the chart above shows, the more frequently interest is compounded, the higher your return.
Types of APY accounts
Savings accounts earn interest based on the account balance. Some banks require a minimum deposit to open the account and they may also require a minimum balance to avoid monthly fees. These accounts may not earn very high interest due to their flexibility and low balances required. However, most of these accounts can be opened for free.
Some banks even offer a bonus for opening an account and setting up direct deposit.
Other accounts may require a minimum balance to earn interest. CITBank requires a minimum balance of $ 100 to earn 1.55% APY. Synchrony Bank only requires a minimum balance of $ 1 to earn 1.55% APY. Granted, you’ll only earn a few cents if you only have $ 100 in your account, but both of these savings accounts charge $ 0 in fees. If either account was opened with $ 10,000 and no further deposits were made for a year, the account would earn $ 156.20 in earned interest income.
Money Market Accounts (MMA) such as CapitalOne require an initial balance of $ 10,000 and a minimum balance of $ 10,000 to earn the APY of 1.5%. If only this $ 10,000 deposit is made, the account would earn $ 151.13 in earned interest income. Compared to other accounts, MMAs are not high yielding interest vehicles, but allow account holders better access to their funds.
A certificate of deposit (CD) is a term deposit. Banks require that the money be left on a CD for a period of time to earn interest. This makes CDs a less liquid asset. However, for the potential payoff, it may be worth it.
For a five-year CD with 2.65% APY, the value of a $ 10,000 deposit on the maturity date would be $ 11,416.73. If the same $ 10,000 had been deposited into the above savings accounts, they would only have earned $ 805.80 in interest. However, savings accounts are more liquid and you can access your funds at any time. CDs lose value if cashed early, not only in the form of penalties and loss of interest, but the initial capital could be affected as well. If you are opening a CD, make sure that you do not need these funds for the duration of the deposit.
Why do banks offer 5.5% loans for a $ 25,000 car loan, but only offer 0.03% APY on savings accounts?
The simple answer? Make money.
If banks offer higher rates for interest-bearing accounts than for loans, people could borrow money from the bank, turn around and open an interest-bearing account. As the account earns interest, the bank would lose money on all transactions. The bank assumes the risk by lending funds. For this risk, they charge the interest on the loan as a gain to secure their repayment.
APR might be easier to calculate, but figuring out additional calculations for APY and compound interest is worth doing some extra brain training. It’s important to know how your accounts are earning you money as well as enough interest for your needs.