It can be confusing, but it plays an important role in reaching your financial goals.
Understanding banking terms that describe interest can be confusing, but interest plays an important role in determining which products will help you reach your financial goals, so it worth looking at more closely.
Interest is “the interest percent that a bank or other financial company charges you when you borrow money, or the interest percent it pays you when you keep money in an account”(1). Simply put, the bank pays you keep your money on deposit because it can use that money for other things (like a loan someone else). In the case of loan interest, you pay the bank a percentage for using its money.
Often, the more money you deposit in the bank, and the longer you commit to leave it there, the higher the deposit rate will be. This is because it is more useful for banks.
There’s more than one type of interest. The first is called Simple Interest. And it is just that: simple. If you deposit $100 for a year and earn 2% interest, you receive $2 at the end of the year and every year after that, as long as the rate doesn’t change and you don't withdraw the money. Easy enough, right?
More commonly with deposit accounts, though, you hear about Compound Interest, which is a little more complicated. With compound interest, you can earn more interest each period because the interest is added to the original amount at the end of the period, which means you earn interest on the interest also. So, if you use the same scenario of $100 and 2%, the first year you will earn $2, but the second year will earn a little more since you will be earning interest on $102 instead of $100 since the $2 was added to the $100 at the end of the first year.
This is where Annual Percentage Yield (APY) comes in (or, in the case of loans, the Annual Percentage Rate (APR) – but we’ll leave that for another post). APY looks at the interest rate and the compounding period to give you a number to represent what you will earn in one year. It’s a way to give you a point of comparison, regardless of the period length, so you can evaluate the interest being offered on multiple products and pick the best one for your situation.
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