Are you interested in interest? Like paparazzi on Lindsey Lohan, interest is everywhere. Hiding in the bushes of every financial situation, it appears, sometimes greeted happily and sometimes with grudging discontent. Either way, understanding how interest works with your money is mucho importante.

What is interest?

In banking, interest is a percentage of money paid to either the bank if you’re borrowing money or to you if you’re depositing money. High interest rates can be a good thing if you’re the one getting paid but obviously a bad thing if you are the one forkin’ over the money to the bank. It’s all relative to who’s getting paid and who’s paying.

The Glory of Compounding

“Okay! Kind of obvious,” you say. But interest can be a deceitful hussy of questionable morals and cleanliness because it does not necessarily represent the true amount of interest being paid. What’s this you say? More trickery? Of course. The banks are jonesin’ for your money so bad that they got the shakes.

The actual amount of interest adding up depends largely on compounding. Compounding is when interest is added to the balance a certain amount of times a year. It could be annually, quarterly, monthly, or whatever the bank voodoos up. The next time that it is compounded, that interest you made from before is added onto the previous balance. What this means is that the more frequently the money is compounded, the more money you will make because you get interest on your balance plus your previous interest.

For example, you have $1,000 and an interest rate of 8%. If you compounded it once (annually), your total amount would be $1,080 at the end of the year. That’s your original sum plus the interest. If you compounded it four times (quarterly), you would get $1,082.43. If you compounded it 12 times (monthly), you would get $1,083. So you get about eighty bucks for not having access to your $1,000? Not impressed? That’s all just in one year. If you invested your money at that interest rate for 10 years with interest that compounded quarterly, you’d get $2,208.04. That’s more than doubling your money. You have your original $1,000 plus an extra $1,208.04. Now think what you could make with more money and time. Granted, that’s a pretty sweet interest rate these days (and virtually unheard of), but you can certainly see what this compounding stuff is all about, right?

APR vs. APY

So, you want to build the world’s biggest farm of giant fire ants, but you need to take out a loan. So you take out a loan in the hopes of some easy answers to fulfill your dearest of dreams. As you peruse the final forms, up pops APY and APR. What does this secret bank language mean and how does it relate to you?

The Annual Percentage Rate (APR) and the Annual Percentage Yield (APY) are the key terms you’ll find in the interest rate world. Banks can make interest look more appealing by showing either the APR or APY. Look for the APY. APY shows the interest you will be paying (or in other cases will be paid) in the most accurate light.

APR and APY’s differences revolve around compounding. They both refer to interest you (or the bank) will make in a year. APR just tells you the amount of interest you can make in a year without taking compounding into account. APY basically represents interest more accurately because it takes into account the number of times the interest is compounded throughout the year. So, if it is only compounded once a year, the APY and APR should be the same.

EXAMPLE!

Say you want to take out a car loan, and whoop-dee-doo, you found a bank that is willing to give you an APR of 5%. But tricky-tricky, it is compounded monthly, so the interest rate is actually 5.116%. In percentages, every little bit counts for a significant something. It is in the bank’s best interest to show you the APR because it makes you think you’re getting a lower rate.

At the same time though, imagine you want a savings account. The bank is offering a 2% APR, but since they are giving you the money, they are going to want to advertise the APY. If it’s compounded monthly, you would actually get 2.018%.

It’s a smoke and mirrors game. They are trying to show you the interest from the best possible angle, but that doesn’t mean you have to play their game. Get a wind turbine. Break the mirrors. Just make sure you see your interest clearly.