Interest rates, whether for savings or loans, can have more than one definition or meaning. A good example of this is the difference between stated interest and effective interest. Stated interest is the specified rate on your savings account or loan. Effective interest is the true rate you earn or pay. There is a difference because a stated interest rate does not take into account the effect of "compounding," which increases the rate you earn or pay.
Savings Account Rates and Compounding
Savings accounts' effective interest rates are usually higher than their stated rates. For example, you may have a savings account with a stated rate of 3.0 percent. Your bank or credit union "compounds" your interest daily. This means that every time they post interest to your account, they pay interest on interest and add it to your balance. Should you keep $1,000 in your account for a year, with daily compounding, you'll earn $30.45, making your effective annual interest rate 3.045 percent.
Loan Interest Rate Differences
Just as compounding works in your favor on savings accounts, it creates even larger differences on loans. The only time a stated -- or nominal -- interest rate on a loan is equal to the effective interest rate is if you borrow, say, $1,000 at 6.5 percent on January 1, and you pay back the $1,000 plus $65 (6.5 percent) on December 31. However, most loans come with monthly installments composed of principal and interest amounts. For example, you get an auto loan, payable in 36 equal payments, at a stated interest rate of 6.5 percent. Over the loan term, your effective interest rate -- called APR (annual percentage rate) -- will equal 12 percent. This is like "reverse" compounding.
Only Mortgages Still Use Stated Interest Rates
Because of the wide difference between stated and effective interest rates for shorter-term consumer loans, few stated rates are ever quoted by lenders. Only APRs are quoted for auto, personal, equity, and education loans. When you inquire about mortgages, you'll be quoted the stated interest rate. However, when you apply, within three days you will receive a Truth in Lending document that displays your APR, which is usually slightly higher than your quoted stated rate.
Savings Accounts Disclose the Annual Percentage Yield
While effective interest rates for lending are called APRs, savings accounts express your annual percentage yield (APY) to display your effective interest rate. Analyzing APYs for different savings accounts helps you decide on your true earnings from each. For example, two savings accounts with stated interest rates of 3.0 percent can have different APYs. Assume one account pays interest quarterly while the other posts interest daily. Keeping $1,000 on deposit for a year in the quarterly posting account earns you 3.034 percent interest. Depositing the same $1,000 in the daily interest account earns you 3.045 percent over a year. The effective interest rate is more accurate -- and more important -- than the stated interest rate.
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