Overwhelming terminology often makes borrowing or lending money for the first time intimidating. This is especially true when comparing types of interest, as there are several easily-confused terms that sound similar but have particularly meaningful differences. Luckily, it’s not as complicated as it might seem. We’ve put together a guide to help differentiate the most critically important interest terms.
How Interest Works
Interest, by its most simple definition, is the cost of borrowing money. Doing so can be an expensive endeavor not only because it requires money “down,” or some financial contribution to establish a personal stake, but also because of the concept of the “time value of money.” This widely-held economic principle states that holding onto money is worth something more than the face value of the money itself due to the money’s potential to earn (to grow through investment) over time.
So when someone borrows, it’s not only the “principal,” or the original loan, that must be paid back. In order to incentivize the lender to lend in the first place, it’s also the cost of that money’s growth potential that must be repaid—making the loan, in essence, an investment in the borrower. Furthermore, interest can serve to compensate the lender for the risk that a loan might not be paid back in full. Generally, the higher the perceived risk of default (or, simplified: “not seeing the money again”) to the lender, the higher the interest charged.
Interest does not always flow from an individual to an institution. In the case of a savings account, for example, an account holder is technically lending money to their bank by allowing the bank to hold it—and due to the time value of money, this is worth something to the bank. A savings account doesn’t pay much interest, but the bank will nonetheless pay, proportional to the amount “lent,” for the privilege of having access to the client’s money.
An interest rate is usually expressed as a percentage of the principal and, depending on the type of loan, it may be subject to fluctuation over time. As with the pricing of most other types of services, the borrower looks for as low an interest rate as possible, while the lender must turn a profit off the service provided but still offer competitive pricing.
Interest rates can vary widely, even within the same category of loan, depending on specific circumstances—and specific types of loans come with specific types of payments, all with their own terminology to remember. What’s most important to know about interest rates is that they convey a specific, quantifiable price for borrowing money that can be applied to loans of all types and sizes.
An annual percentage rate describes the interest rate a borrower pays on a yearly time frame, even though the loan’s pay periods are likely much more frequent. APR speaks specifically to the cost of borrowing money, whether that’s for a mortgage, a car or a credit card. APR represents a loan’s periodic rate (the interest rate given for a specific time period, such as a day or a month) multiplied by the number of periods in a year. This makes it a useful point of comparison, as the annualization provides a common reference for all sorts for loans with different periods and terms.
One important distinction about APR is that it does not take into account compound interest—interest that is calculated off the principal plus accumulated interest from previous periods, rather than just the principal. Because of its usefulness for comparison, APR is still often employed to describe loans with compound interest—such as credit cards—even though it will undershoot the actual cost to the borrower. This is why it’s sometimes called a “nominal APR.”
The annual percentage yield, also known as “earned annual interest” (EAR), is another way to express an interest rate. It’s mostly used by banks and investors to describe the rate of return to the client when the client is the one “lending,” as in the case of a savings account, or with a certificate of deposit (CD), individual retirement account (IRA) and so on. It tells the lender how much money their money is making in interest.
Unlike APRs, APYs do account for compound interest, and as such they express an investment’s true yield to the lender—though unlike APRs, they don’t also account for any ancillary fees. APYs often describe a rate with a higher figure than a nominal rate; the higher the frequency of compounding, the greater the difference between the two. This is part of why APYs and APRs have come to find such different uses even though they represent similar concepts.
When lending, a financial institution will advertise APR, because without the added value of compound interest, the interest rate appears lower and more desirable to the borrower. When that same institution wants to attract investors, it advertises APY, which will look like a higher number, representing a more attractive interest rate to a potential lender.
It doesn’t matter whether you are taking out a mortgage, applying for a credit card or setting up a savings account—it’s important to understand interest rates and the common representations. APRs and APYs both offer vital insight into the loans and investments they describe, though it’s necessary to be wary of the limitations of each at the same time. While APYs are often a more realistic indicator of interest owed, APRs can be more illuminating of the other costs associated with borrowing besides an interest rate. With an understanding of these differences, a consumer can consider his or herself armed with the ability to draw effective conclusions from these common ways of describing interest.
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