What is the annual percentage return?

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When you invest or borrow money, it is important to understand how much you are likely to earn or owe. The Annual Percentage Return, or APY, can be a useful tool to help you make this decision. The annual percentage return is the interest rate earned or accrued over the course of a year taking into account the effect of compounding. It is based on the annual percentage rate and how often interest on a loan or investment is compounded. The annual percentage return can give you a better idea of ​​the actual return on an investment and the actual cost of a loan.

Compounding
When you borrow or invest money, the total amount of interest you pay or earn depends on how often that interest is compounded. Compound interest is interest that is added to the capital of an investment or loan so that the Additional interest also pays off. In other words, membership is a way to earn or charge interest on interest, and it leads to exponential growth in capital gains and debt.

Compounding can be a good thing or a bad thing depending on whether you are an investor or a borrower. As an investor, compounding is a good thing because it allows you to make money not only on your initial investment, but also on the interest it earns. Suppose you invest $ 5,000 at an interest rate of 8%. After one year, you will have $ 5,400 (your first $ 5,000 plus $ 400 in interest). When you invest that money the following year, you will be able to earn interest not only on that $ 5,000, but also on the $ 400 in interest you have already earned.

While compounding can do wonders for investors, it can be a bad thing when taking out a loan because it increases the amount you will end up paying to borrow money. The more interest is compounded on a loan, the more interest you will pay over time. If the interest rate is high enough and the interest is compounded often enough, the accrued interest may ultimately be more than the principal owed.

APY vs APR
The Annual Percentage Rate, or APY, is the interest rate you will earn or owe regardless of capitalization, whereas APY is capitalization based. For this reason, when looking at a loan or investment, you will often notice that the APY and the APR are different, and the larger the gap between them, the more often interest is compounded over the life of the investment. or loan. .

If you owe money on a credit card, your APY will almost always end up being higher than the APR shown on your card because interest charges are added to your balance for each month you don’t pay it. This means that over time you will end up paying interest not only on the principal you owe, but also on the interest.

This article is part of The Motley Fool Knowledge Center, which was created based on wisdom collected by a fantastic community of investors. We would love to hear your questions, thoughts and opinions on the Knowledge Center in general or on this page in particular. Your contribution will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thank you – and crazy!

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