Annual Interest Rate Vs. Annual Yield
The annual interest rate, also known as the annual percentage rate (APR), and annual percentage yield (APY) are two measures of how much interest accrues in your interest-bearing accounts and how much interest you might be charged on a loan.
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Function
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The annual interest rate assumes that the interest is compounded only once per year. The annual percentage yield takes into consideration the effects of interest compounding, which will increase the amount of interest that accrues.
Conversion
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To convert from an annual interest rate to an annual percentage yield, divide the annual interest rate by the number of times per year that interest is compounded and then add 1; raise the result to the Nth power where N is the number of times per year that interest is compounded; and subtract 1 from the result. You can also use an online calculator. (See Resources.)
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Frequency
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The more times interest is compounded per year, the bigger the difference between the APR and APY.
Considerations
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Banks often quote the annual interest rates for loans, but the annual percentage yield for deposit accounts. Make sure that you know which measurement of interest is being quoted so that you're not comparing apples and oranges.
Fun Fact
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Albert Einstein once called compounding interest "the most powerful force in the universe."
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