Banking institution question - Sorry to interrupt your relaxation this dreary but lovely Saturday morn...
Why do banks print interest rates twice in most informative descriptions of account options? For example, why are there 2 rates? What does the first rate relate to? The 2nd I realize would be the annual percentage yield (or the percent received on your account over the year's period).
Savings Acct: .02%/1.00% APY
Have seen and been confused by this continually AND most banking employees, when posed with this question, generally do not offer a complete or intelligent explanation.
In general, there are two federal laws,truth-in-lending and truth-in-savings, which require disclosure by financial institutions of the terms and conditions under which interest is charged(loans) or paid(deposits) on accounts. One important consideration for consumers is the frequency (how often) interest is computed - called "compounding".
Most interest is quoted on "an annual basis"- or in other words, how much you would earn in one year. So, if the annual rate, simply paid at the end of 12 months on your $100.00 savings deposit were 1.00%; you would receive $1.00 in interest. In this example, your "annual percentage rate"(APR) is 1.00% and your "annual percentage yield"(APY) (the actual amount of interest you receive) are the same, because the frequency of compounding is just once a year. In receiving the required disclosure, you would see 1.00%APR/1.00%APY.
If your account were "compounded daily", you would earn more interest. In the example, your annual rate is still 1.00%(APR), but instead of just computing interest once at the end of 12 months; your interest is computed at the end of each day! (No you don't get 1.00% a day!! you receive 1.00% divided by 365 each day.) The power of compound interest is that "interest is paid on interest" which means you earn more and your account grows faster. For example, at the end of the first day your $100.00 has been increased by the small amount of daily interest computed; so tomorrow interest will be calculated on that new slightly higher balance - which means you will earn a little bit more each day as the year progresses. At the end of 12 months, you will have earned $1.01 with daily compounded interest rather than just the $1.00 you would receive without compounding. Your annual rate(APR) is still 1.00% but your annual percentage yield (what you actually earned) is 1.01%(APY). The disclosure you receive would now say: 1.00%APR/1.01%APY.
Consumers are generally better off with accounts that are compunded most frequently - daily is better than monthly which is better than quarterly which is better than semi-annually, etc. It's usually best to compare yields not rates when deciding which account is better - but watch out for other terms such as fees, penalties, minimum balance requirements, etc. What appear to be "high rate" accounts are frequently loaded with "gotchas" and "tripwires" which often make those seemingly higher rates difficult to achieve. Be very, very suspicious if the rate looks too good...don't get fooled!
(That's the "short answer", don't you wish you hadn't asked!)
2 comments:
Banking institution question - Sorry to interrupt your relaxation this dreary but lovely Saturday morn...
Why do banks print interest rates twice in most informative descriptions of account options? For example, why are there 2 rates? What does the first rate relate to? The 2nd I realize would be the annual percentage yield (or the percent received on your account over the year's period).
Savings Acct: .02%/1.00% APY
Have seen and been confused by this continually AND most banking employees, when posed with this question, generally do not offer a complete or intelligent explanation.
Thanks
In general, there are two federal laws,truth-in-lending and truth-in-savings, which require disclosure by financial institutions of the terms and conditions under which interest is charged(loans) or paid(deposits) on accounts. One important consideration for consumers is the frequency (how often) interest is computed - called "compounding".
Most interest is quoted on "an annual basis"- or in other words, how much you would earn in one year. So, if the annual rate, simply paid at the end of 12 months on your $100.00 savings deposit were 1.00%; you would receive $1.00 in interest. In this example, your "annual percentage rate"(APR) is 1.00% and your "annual percentage yield"(APY) (the actual amount of interest you receive) are the same, because the frequency of compounding is just once a year. In receiving the required disclosure, you would see 1.00%APR/1.00%APY.
If your account were "compounded daily", you would earn more interest. In the example, your annual rate is still 1.00%(APR), but instead of just computing interest once at the end of 12 months; your interest is computed at the end of each day! (No you don't get 1.00% a day!! you receive 1.00% divided by 365 each day.) The power of compound interest is that "interest is paid on interest" which means you earn more and your account grows faster. For example, at the end of the first day your $100.00 has been increased by the small amount of daily interest computed; so tomorrow interest will be calculated on that new slightly higher balance - which means you will earn a little bit more each day as the year progresses. At the end of 12 months, you will have earned $1.01 with daily compounded interest rather than just the $1.00 you would receive without compounding. Your annual rate(APR) is still 1.00% but your annual percentage yield (what you actually earned) is 1.01%(APY). The disclosure you receive would now say: 1.00%APR/1.01%APY.
Consumers are generally better off with accounts that are compunded most frequently - daily is better than monthly which is better than quarterly which is better than semi-annually, etc. It's usually best to compare yields not rates when deciding which account is better - but watch out for other terms such as fees, penalties, minimum balance requirements, etc. What appear to be "high rate" accounts are frequently loaded with "gotchas" and "tripwires" which often make those seemingly higher rates difficult to achieve. Be very, very suspicious if the rate looks too good...don't get fooled!
(That's the "short answer", don't you wish you hadn't asked!)
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