What Is the Difference Between Compound Interest and APR?
Although the terms "compound interest" and "APR" are often evoked together, they do not have the same meaning. APR stands for Annual Percentage Rate and is an estimation of the yearly costs of a loan or accumulation of interest. Compound interest is the mechanism by which the principle of loans (or savings) grow. Read on to learn how this affects your borrowing and savings.
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Types
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Generally speaking, APR is the rate of interest times the amount of payment periods throughout the year. This generally refers to the rate borrowers pay to financial institutions or creditors. Nominal APR is the rate compounded monthly on a loan or credit agreement.
APY (Annual Percentage Yield) represents the yearly interest rate that adds on the cost of compounding interest. This term usually refers to the interest rate a financial institution pays to a lender. An APY is also the percentage an investor earns as the difference between the initial and final account balance during one year.
However, in many loan terms (particularly mortgages), APR represents the estimated cost of the loan for the year. While the interest rate factors into this figure, other elements are also considered, including financing charges, taxes, insurances and other fees.
Function
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Compound interest rates represent the accumulated interest added back to the principal amount. This means that the lender earns interest upon interest, compounded either monthly or annually.
Compound interest can also work in your favor--if you are the lender. Government bonds, certificates of deposits and savings accounts are, essentially, loans that you give to the the government or a bank. While the bank holds your money, you collect interest, which is added back to the principal.
For example, if you begin with $100,000 at an APR of 3 percent, you will accumulate $3,000 in interest by the end of the year, giving you a total of $103,000. The next year, you will accumulate interest on the new principal, giving you a total of $106,090. This continues recursively for as long as you leave the money in the bank. In five years, that $100,000 will have grown to $115,927. In ten years, it will be $134,391. As you can see, the amount of interest gained grows each year as the principal grows.
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History
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Although compound interest is a familiar concept in modern day financing, compounding interest was viewed as an unconscionable practice in early civilizations and was punishable by law. Over the centuries, this practice continued to be viewed unfavorably and was legally condemned in countries throughout Western civilization. Compound interest was once termed "anotocism," and signified the highest interest rate permitted on loans and property deeds.
This type of interest is mentioned specifically in the Koran, which deems the practice a sin despite the fact that compound interest is widespread in many Muslim countries.
In the Christian New Testament, money lending is also viewed as a greed-driven sin. Unscrupulous money lenders, called usurers, were known to charge exorbitant interest rates to those that depended on their financing.
In 1968, the U.S. federal government enacted the Truth in Lending Act, which was designed to shield clients from creditors such usury by mandating full disclosure of lending terms. In mortgages, this is when the disclosure of APR became required. The Truth In Lending Act clearly delineates how APR must be disclosed and how it must be figured.
Geography
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U.S. lawmakers govern the calculation and explanations of APR under the Truth in Lending Act. In the United States, APR generally refers to the periodic interest rate multiplied by the amount of compounding periods in one year.
In both the United States and the United Kingdom, creditors are required by law to inform borrowers of the APR before a loan agreement is made. Canada uses semi-annual compound interest in its loans in the mortgage sector and other markets.
In the European Union, each member state decides which cost considerations will be represented in the calculation of APR.
Warning
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Consumer advocates warn that APR as quoted for credit card holders generally refers to nominal APR as opposed to the Effective Annual Rate (EAR).
Furthermore, these professionals point out that some types of fees are excluded in APR calculations, which would add on considerable costs to the rates quoted by credit institutions. These additional costs may include late fees, one-time fees, and other penalties enacted by the lender.
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