Float Finance 5.2: Interest, Compounding, and APY
Float Finance is an ongoing series breaking down the basics of personal finances and money
In our last article we discussed different places to build savings and why savings matter. One benefit we mentioned was the interest you can earn in some types of bank accounts. But how does interest and compounding work?
Interest and Compounding
“Interest” is the money financial institutions pay you for the money you keep deposited in your account with them. Interest is expressed as a percentage. How much interest you earn is based on how much money you have in your account, the interest rate (percentage), and how long you keep the money in your account.
“Compounding” is interest you earn on your interest. You earn interest on the amount of money you deposit and leave in your account. You will continue earning more interest on an interest you leave in your bank account. You can think about it like rolling a snowball in the snow: you start with a small ball and as more snow is rolled on it (think of interest as being the snow) it gets bigger. This causes there to be a bigger surface for even more snow to gather on the snowball’s surface. That’s pretty much how compounding interest works.
How often your interest compounds makes a difference in how much money you earn. There more often it compounds the more interest you earn each year. Daily or continuous would be the best, but many accounts will compound monthly or quarterly.
So, what does this look like in action? Let’s compare leaving money in a jar at home or in a savings account with 2% interest:
Remember, it’s not just interest and compounding that matter. Any money you add to your account matters too! Over time, regularly saving money (even small amounts) adds up! Let’s see what happens if you save $5.00 each month:
Saving just a little can add up.
Annual Percentage Yield (APY)
APY reflects the amount of interest you will earn on a yearly basis (or pay on a loan). It is expressed in a percentage. APY is not the same as the interest rate- it is the interest you would earn each year if you keep the interest you earn continuously throughout the year. Since APY takes compounding into account, it is a great way to compare potential earnings from different accounts.