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Finance Friday: Savings Accounts Definitions of Annual Percentage Rate and Annual Percentage Yield

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The question of many customers in the calculation of savings, especially time deposits, are the difference of Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The best example is to look at a Certificate of Deposit or Time Deposit. Let’s examine a possible scenario, a customer has $25,000 to invest in a safe savings vehicle or instrument where the choice is for interest to be paid per month directly to the customer or reinvest the interest into the $25,000 to make the balance larger when interest is paid against the time deposit vehicle. The $25,000 will be in a Cerfiticate of Deposit (CD) for 60 months. The institution is posting the following rates and yields on this deposit amount.

$25,000 60 months 4.00% APR 4.07% APY

The simple calculation is first the APR. The calculation of $25k x .04(4.00% APR) = $1000 interest per year. The total of 5 years of interest at the basic APR is $5,000. That is monthly interest being credited to the customer or paid monthly and not invested back in the CD. The customer wants to have interest to be reinvested in the CD after the interest is paid monthly. APY is the rate of compounded the interest over time back to the principal deposit of $25,000. After the first month of interest is paid, the $83.33 will credit to the $25,000, and the 4.00% interest is paid on $25,083.33 for the second month. The compounding interest payment will raise the total amount of interest paid from $5000 on a 4.00% APR CD since the interest is reinvested in the CD to a total of $5,524.91. That increase would be based on a yield of 4.07% over the 60 months.

The following two calculators show the CD with a 4.00% rate but a 4.07% yield.

Financial Calculator Financial Calculator2

$25,000 CD, 4.00% interest rate does not post a yield if interest paid monthly is taken from the CD to be paid to the customer in a checking or savings account at $83.33 monthly, or the rate does not pay interest but one time at maturity of CD or time deposit or $5000

Interest paid monthly on the same aforementioned situation, but the monthly interest is paid back into or reinvested into the CD until maturity. Then, the yield would be higher than the rate because of compounding interest. The total interest paid $5524.91 or $524.91 more by reinvested interest back into CD.

This example is for savings, but the same holds true in borrowing money. However, this first example is the impact of rate and yield is on savings. The basic definition for a customer to understand is examining the APR and APY on accounts like CD or Time Deposit Accounts.

 

It is often purported that Albert Einstein referred to compound interest as the greatest force on earth. Strong words from one of the smartest men to ever live. Although this article’s intention is not to ponder Einstein’s most compelling views, we do intend to demonstrate the importance of understanding the difference between annual percentage rate (APR) and annual percentage yield (APY). For most people, these terms are applied to loans and investment products, but they are not created equal and they significantly affect how much you earn or must pay in these transactions.

 

Investopedia explains ‘Annual Percentage Yield – APY’

The APY is similar in nature to the annual percentage rate. Its usefulness lies in its ability to standardize varying interest-rate agreements into an annualized percentage number.

For example, suppose you are considering whether to invest in a one-year zero-coupon bond that pays 6% upon maturity or a high-yield money market account that pays 0.5% per month with monthly compounding.

At first glance, the yields appear equal because 12 months multiplied by 0.5% equals 6%. However, when the effects of compounding are included by calculating the APY, we find that the second investment actually yields 6.17%, as 1.005^12-1 = 0.0617

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Filed under: Article Content Future Publication, Current News Event, Donny Wise Live in Personal Finance, Examiner.com- DC Consumer and Banking Examiner, PERSONAL FINANCE NEWS, Real Time News, Uncategorized Tagged: Annual percentage rate, Annual percentage yield, APR, Certificate of Deposit, Compact Disc, Interest, Options, personal finance, Time Deposit

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