Often times people are confused about the interest rate when shopping for car loans and mortgages. Then they wonder if that rate can be compared to the interest they earn on an investment.

Typically, two different rates are quoted: Annual Percentage Rate (APR) is quoted when you're borrowing money and Annual Percentage Yield (APY) is quoted when you're investing money.

First an explanation of compounding. Let's say you invest $100 and you're going to earn 6% at the end of a year. That means you'll have $106.00 at the end of the year. (By the end of this post you'll know if that is APR or APY.) Then, that $106.00 earns 6% and at the end of year two you'll have $112.36. Kinda cool, right? An easy way to figure this is called the rule of 72. It's not exact, but pretty accurate. Take the interest you're earning, divide it into 72 and that's how long it takes your money to double. In our example, we're earning 6%; 6 goes into 72 twelve times, so in 12 years you'll have $200.

Albert Einstein said compound interest is the most powerful force in the universe.

APR does not take compounding throughout the year into account. So, if you're paying 1% each month, your APR is 12%, which is 1 X 12. Credit cards and other lenders will quote you APR and you'll soon see why. If you carried a balance on your credit card for one month and paid it off, you'd be paying 12%.

However, if you carried that same balance you'd be paying a higher rate of interest because you're carrying the balance and therefore compounding takes effect. That's when APY comes into play and the formula for calculating APY is much different than multiplying the rate times the number of periods as we did for APR. The APY formula is (1 + rate) raised to the power of the number of periods, then subtract one. So, we're paying 1% per month for 12 months, the calculation is: (1+.01) to the 12th power, then subtract one, or 12.68%.

Now you can see why creditors will quote you the APR and the banks where you're depositing your money will quote you APY. You have to be very careful with the rate quoted, not only when you are borrowing money, but also when you're investing money.

If you go to your credit card statement, you'll see the APR. Let me know what you come up with when you convert it to APY in the comments below. [Take APR, divide by 12, then (1 + what you just calculated) raised to the 12th power, then subtract one.]

CategoriesCredit & Debt