By Luis Dominguez
Union Bank, N.A. Vice President and Branch Manager Miracle Mile
Whether you are borrowing money for a large purchase, such as a home or business, or are deciding where to invest your savings, interest rates can be a key factor. Interest is the cost of borrowing money, and is based on the concept that lenders are entitled to a return on their investment. Interest compensates a lender for allowing a borrower to use their money for a period of time, and assuming the financial risk of doing so. This also applies to when one deposits money into an interest-bearing account. They are essentially “lending” money to a financial institution that it can in turn use to make loans, so the depositor is paid interest on their deposit. The amount of interest paid on a loan depends on a number of factors: the dollar amount loaned or borrowed, the interest rate, length of time involved in the transaction and the repayment schedule, and the method used to calculate interest.
Simple interest Whether making a deposit into a savings account or obtaining a loan, interest is expressed as a rate and is calculated as a percentage of the total amount borrowed (the principal). Simple interest is figured once. For example, if you purchase a $1,000 savings bond at 5 percent interest, you would earn $50 in interest at the end of the year in simple interest.
Compound interest Compound interest is interest paid on the principle as well as previously earned interest, so the money you earn in interest becomes part of the principal, and also starts to earn interest. If you are saving money in an account, compound interest works in your favor by increasing your earnings. Compound interest works the same way for certain loans and credit cards, but in these cases grow the outstanding balance, making it increasingly difficult to pay off the loan if only the minimum payment is made.
Periodic Interest Rate Interest rates are often quoted on an annual basis. However, most financial institutions do not calculate interest annually, but rather at the end of a certain time period, such as semi-annual (every six months), quarterly (every three months), monthly (12 times per year) or even daily (365/366 times per year). The more frequently an investment or debt compounds, the more quickly the principal grows, so in order to calculate how much interest is being charged or earned over each compounding period, you must consider the periodic interest rate. The periodic interest rate is the interest rate charged on a loan or realized on an investment over a specific period of time. This calculation is made by dividing the annual interest rate by the number of compounding periods.
For example, let’s say you have $1,000 in an interest-bearing account that is earning 5 percent interest and the compounding period is monthly, instead of annual as in the previously mentioned savings bond scenario. The interest is calculated monthly and therefore as 1/12th of 5 percent, or 0.417 percent each month. When calculated this way, the account will yield $51.20, thanks to the compounding interest effect taking place on a monthly basis.
APR vs. APY Interest rates are also often quoted as an annual percentage rate (APR) or an annual percentage yield (APY). The APR reflects the measure of interest on an annual basis without taking into account compound interest. The APY is the same interest rate measure, but it takes into account the interest rate and compounding period to give you a single number that represents how much you will earn from that investment in one year.
As in the previous example, the account that paid $51.20 in interest due to compounding monthly interest had an APY of 5.12 percent, even though the APR was 5 percent. APR and APY are tools that give you a single number to help you compare “apples to apples” when shopping for financial products. When in doubt, it may helpful to consult your banker or financial advisor to walk you through and give you an accurate picture of the impact interest rates have on your financial future.
The foregoing article is intended to provide general information about interest rates and is not considered financial or tax advice from Union Bank. Please consult your financial advisor.