Compound interest is one of your best friends in your wealth building journey. In fact, even Einstein argued that compound interest was the greatest force on earth! That’s saying a lot from a man who dedicated his life to the forces of the universe.
Essentially, when your interest compounds, you earn interest on top of your interest! Even simpler, Benjamin Franklin said “Money makes money. And the money that money makes, makes money." Therefore, the longer that you invest or save, the more you can take advantage of compound interest.
Two common tools that use compound interest are APR (annual percentage rate) and APY (annual percentage yield). While they are both used in savings accounts, investing, credit, and more - it’s important to understand the big differences between the two.
APR: ANNUAL PERCENTAGE RATE
Before we really dive into how APR works and how it impacts you, you may have seen this equation:
APR = Periodic Rate × Number of Periods in a Year
Let’s say that you got a new credit card. They might say that you have to pay 2% interest every month. Therefore, the APR = 2% (periodic rate) x 12 (number of periods in a year). So the APR of the credit card is 24%.
Oftentimes, credit card companies will compound that interest monthly, or even daily! So what does that mean for you? Well, let’s take a look at the following example.
In our example, we can see that every month that we don’t pay off our purchase we have to pay more and more in interest.
However, instead of always paying 2% of $100 or the cost of the shirt, we have to pay compound interest. After one month we pay 2% of $102, then 2% of $104.04, and so on.
So what does this mean for you? Well, first off, you should realize to never carry a balance on a credit card. You can avoid carrying a balance by setting up automated payments on your credit card!
This way, you don’t even have to worry about forgetting to pay it off. Make sure to select "pay off full statement" not "pay off minimum payment". If you only pay off the minimum payment, that will only be paying off "the smallest amount per month to avoid a late fee". You will still be carrying a balance and paying interest if you don't select "pay off the full balance".
But also, you should choose a credit card with a low APR in case you ever do carry a balance. If possible, finding a credit card that compounds monthly instead of daily will save you a TON in interest.
APY: ANNUAL PERCENTAGE YIELD
Once again, we find ourselves in front of yet another equation.
APY = (1+Periodic Rate)Number of Periods-1
This one looks a little more confusing, but I promise, it is so much more rewarding. Let’s break it down. Let’s say that your credit card company offers 1% interest, compounded monthly.
Periodic Rate = 1% or 0.01
Number of Periods = 12
APY = (1 + 0.01)12-1= 12.68%
See! Not too bad. But what do all these numbers mean to you? Let’s break it down in another example.
This time, we invested $100 into a Savings Account with a 12.68% APY, compounding monthly. (Wow, wouldn't that be a dream come true! Haha)
After 1 month, we earn 1% on our investment. 1% x 100 = $1. We now have $101 in our savings account! This process repeats again the following month, 1% x $101 = $1.01, and we have $102.01!
Now this doesn't seem like much, but check this out.
In 10 years, with no additional investments, our $100 would turn into $353.02. Without doing anything at all, we have more than TRIPLED our initial investment. If you’d like to calculate your own interest, and getting a cool graph like the one below, check out this compound interest calculator.
So what does it all come down to?
We have two concepts: APR and APY. Both utilize compound interest and can have serious impacts on your financial health, positively and negatively. Here's two golden rules.
1. You want a LOW APR.
APR is essentially calculating how much EXTRA MONEY IN INTEREST you have to pay. You always want to select a low APR when paying back interest on a loan or a credit card.
2. You want a HIGH APY.
APY is calculating how much MORE MONEY IN INTEREST you will get from an investment/savings. Therefore, the higher the APY, the more interest you will earn every single year.