Before you can decide if one loan or deposit account is better than another, you must first become familiar with a few key personal finance terms. Understanding the differences between various rate terminology makes selecting a money market account, credit card, or another account that charges or pays interest an easy one.
Interest rates reflect the cost of borrowing money. Your monthly payments are based on the interest rate in your loan agreement or credit card disclosure document. Rates can stay the same (fixed) or change over time (variable or adjustable).
Compound interest is powerful. It can cost you more money than you planned or help your money grow faster than you'd imagined. In either case, interest is first applied to the initial balance of a loan or deposit account. At regular intervals, additional interest charges or earnings are applied to the new balance which includes the prior interest charges or earnings.
Compounding may occur daily, monthly, quarterly, or annually.
Annual Percentage Rate (APR)
An annual percentage rate is the total yearly cost of borrowing money, including the interest rate and other applicable fees and costs. When comparing two loans with the same APR, ask about the compounding frequency since it is not factored into the rate. Remember that the loan may compound daily, monthly, quarterly, or annually. The lower the APR and less frequent the compounding, the better the deal.
For example, an APR of 10.5% that compounds annually applied to your balance once at the end of the year will cost less than 0.87 percent (10.5% divided by 12 months) on your loan balance monthly.
REMEMBER: The APR gives a more accurate picture of how much you'll pay since it considers the interest rate along with other costs.
Deposit rates are expressed as percentages and represent the money a financial institution pays you to keep funds in your account. Earnings vary and are often based on the account balance, dividend rates, and annual percentage yield.
If money deposited into an interest-bearing account at a credit union meets certain requirements, it earns dividends. Deposits are used to fund mortgages and loans for other members without affecting the depositor's account balance. Since credit union members are part-owners, profits from lending money to other members are distributed to eligible account holders based on account type.
Banks may use the term "interest payments" instead of "dividend rates" and determine those payments based on multiple factors. Some include competitor rates, market conditions, and Federal policies.
Annual Percentage Yield (APY)
Annual percentage yield is the amount you can earn from your original deposit over one year. The APY factors in compounding frequency, which is typically daily, monthly, or quarterly. The more frequent the compounding, the faster your account balance can grow.
A term is the length of time, typically measured in months, that the borrower is given to repay the money borrowed from a lender or creditor. It can also represent the length of time you can earn money at a set rate.
Rates, terms, and yields can vary significantly by financial institution. Use what you've learned here to help compare and select accounts that support your financial goals.