Initially, compound interest pays you interest on the principal amount of money. Then when it's time to pay interest again, you are paid on the principal AND on the previously earned interest. The interest you earn adds to - and becomes part of - the principal that accrues interest in the next period. (Here's an example: a $100 deposit earning 5%, compounded annually. In the first year you will earn $5, $5.25 in year 2, $5.51 in year 3, $5.79 in year 4, $6.08 in year 5, and so on. Simple interest would only accrue on the principal and is usually used for periods of less than one year.) Compounding is what makes seemingly small amounts of money grow to millions over time.

APY and APR
These are also interest rates:

APR (Annual Percentage Rate)- This is the annual rate of interest without taking into account the compounding of the interest. APR is often quoted for loans and credit cards; it appears LOWER because it does NOT take compounding into account.

APY (Annual Percentage Yield)- This takes into account the effects of compounding. When you deposit money this is the rate typically quoted, as it appears higher. These rates attempt to highlight high figures to investors and low figures to borrowers.

A credit card company might quote an APR of 12% (for interest compounded monthly of 1% per month) which is APY of 12.68%

Here's an example:

A credit card company charges 2% interest. Since this interest is charged each month the APR would be 24% (1% x 12 months = 24%). The APY rate includes compound interest and a 2% rate of interest compounded monthly would equal [(1 + 0.01)^12 - 1= 26.82%] 26.82% annually. If instead of paying off your bill each month you are among the many who carry a balance on your credit card for only one month you will be charged the APR rate of 24%. But if you carry a balance for the entire year, you will pay 26.82 because of interest compounding every month.


Marion R. Syversen, MBA - President
NorumbegaFinancial
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Marion@NorumbegaFinancial.com
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