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Understanding compound interest, APR and APY for debts, savings & investments

Photo by Elvert Barnes on Flickr

Understanding compound interest, APR and APY for debts, savings & investments

‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.’

Albert Einstein

Compound Interest is an important concept to understand when making decisions on debt, savings and investing. Ultimately, it is important to understand for your freedom and financial independence.

And seeing that’s what we’re all about, I thought I’d cover it here.

The basics of simple interest

Interest can be a good or bad thing, depending on your scenario. It is usually quoted as Annual Percentage Rate (APR). This is useful for making very ‘simple’ comparisons over a one-year period.

However, in reality what you actually pay (or receive) will be different due to compounding or ‘compound interest’, which we’ll get to later.

For now, let’s look at ‘simple interest’ over a one-year period.

Debt (interest is bad)

If you are in debt and owe money eg for a loan or credit card, you will be charged interest on the ‘principal’. In this case, interest is bad; You want the lowest interest rate possible.

Examples:

  • A $100,000 loan at 20% APR = $120,000 to pay after 1 year
  • A $100,000 loan at 10% APR = $110,000 to pay after 1 year

So, if taking a loan (or getting a new credit card) you want to go for the lowest APR. However, if you are deciding which of your debts to pay off, you would choose to pay those with the highest APR first.

Make sense?

Savings (interest is good)

If you have money in savings, you will be paid interest on the ‘principal’. In this case, interest is good and you want the highest interest rate possible. Sadly, the banks hardly pay any interest these days.

Examples:

  • $100,000 savings at 2% APR = $102,000 after 1 year
  • $100,000 savings at 1% APR = $101,000 after 1 year

So, if looking for a savings account, you want the highest interest APR.

Compound Interest

Now that we understand simple interest lets explain compound interest.

‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.’

Albert Einstein

Compound interest is interest that is charged on both the principal plus previous interest. In most cases, interest compounds regularly at a given rate.

Frequency of compounding is important!

When talking about compound interest it is crucial to understand the frequency of compounding and the impact it has.

In the ‘simple interest’ examples above, the compound frequency was 1. Basically, this means the interest was applied only once; at the end of the year.

In reality this rarely happens.

If APR interest is calculated monthly, it would be seen to have a compound frequency of 12. If it calculates daily, the frequency would be 365.

This is important to know as the more times something compounds the larger it gets, and faster!

Higher compounding frequency = higher/faster growth

Lower compounding frequency = lower/slower growth

Which brings me on to the next question…

Is daily or monthly or annual compounding better?

If you’re keeping up, you’ll realise this depends on if you are in debt or are saving/investing.

If you are in debt, you would prefer a lower frequency eg. annual (rarely happens!) and if you have savings, you would prefer the higher frequency eg. daily.

Compound interest is most important to pay attention to when:

  • The principal $$$ is high
  • The duration is long
  • The APR of interest is high

For example, your pension will be of high value (the ‘principal’ is a lot – and you’re probably adding to it each month), you will be invested for many years – possibly decades. Whilst you will not be given an APR value for your pension, you can potentially look at the past performance of its performance.

Longer term investments with high potential return will grow more quickly if you can compound more frequently, which brings me to APY…

What is APY?

APY is ‘Annual Percentage Yield’ it calculates the total yield (return) for a year for a given investment, taking into account compounding. It is a term usually used to compare investment opportunities or past performance.

For example, you have $100,000 at 12% APR and the compounding rate is monthly, then at the end of month one, you would have $101,000. The next monthly calculation would be based on $101,000 (instead of $100,000)…and so it would grow much faster than if it were only calculated at the end of the year.

  • This tool allows you to convert APR to APY and visa-versa.
  • This tool can calculate compound interest at various rates and frequencies.

Does APR = APY?

No. APY takes into account compounding, whereas APR does not.

However, APR would equal APY if the compounding rate is one ie interest is only calculated and applied at the end of the year. This rarely (never?) happens and so APY is generally always greater than APR.

APY in cryptocurrency

If you’re in crypto and are looking at farming or liquidity pools etc for yields then understanding APY is crucial. The big thing to remember is ‘A for Annual’.

Very often you will see massive APYs, and when you do, think; ‘A for Annual’!

Many opportunities are short-term in regards the massive APYs quoted and whilst they are good for getting an indication, you need to look a bit deeper to see what they might actually be worth. It is highly unlikely those rates will last for a year – tomorrow that APY could be half!

I’ll do some posts on crypo and staking etc in the future, for now I just wanted to give you a ‘headsup!’

Vanlife roundup

In general, if you have debts, it is preferable to pay them off before saving as the interest rates on the debt are probably much higher than any savings account and they do compound.

Despite there being great ‘investment’ opportunities out there, with seemingly great APY, I’d always air on the side of caution and generally get rid of debt before saving or investing.

However, there is  such a thing as ‘good debt’ and low-interest debt that is perhaps best not to pay off ahead of other activities. I’ve covered that a bit here:  Should you pay off debt, save or invest before living in a van?

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Disclaimer: As with everything on this site, this article is for informational purposes only and is not advice of any kind. I simply share my experiences and my opinions for information. I am not a financial adviser and I am not providing investment advice or financial or legal advice of any kind. Cryptocurrencies (and most business opportunities) are high risk. Many of the opportunities I discuss exist in new, high risk and unregulated markets. Some methods require significant investment of time and/or relevant skills. Please do your own research and due diligence; do not blindly follow anyone!

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