I am frequently asked how interest rates work on money that is in a savings account or CD, as well as on loans.Â Interest rates can be somewhat confusing, but once you understand the basics they are very simple to calculate.Â Understanding how to calculate interest is very importantÂ when making financial decisions.Â Â

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**Interest on your Savings or CD **

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Have you ever notice how a bank will quote an annual percentage rate (APR) and an annual percentage yield (APY)? Do you know the difference?

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**The Good**

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**APR**â€“ The APR is the actual rate that will be applied to your money.Â This rate is for the entire year, not just per month or day.Â That is important in understanding how much interest you will get.Â An example would be if you have $10,000 and put it in a savings account offering .50% APR you would receive $50 for the year.Â In order to calculate this, you would enter into a calculator $10,000 X .005% = $50.Â Make sure you are not entering .5%, because that is 50%.Â

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**APY**â€“ The APY is used when the interest rate or APR is compounded on a quarterly, monthly or daily basis.Â The APY takes making interest on interest, therefore will represent a higher interest rate than the APR will be.Â For example, earlier I showed how to calculate the interest you will make for the year.Â That only works if the rate is compounded on an annual basis.Â Most banks calculate on a monthly or daily rate.Â In order to calculate this, you must find the rate of interest that is calculated for your compounding schedule.Â Letâ€™s use a monthly compounding schedule, and use the same .50% interest rate.Â To get the monthly APR, divide .50% by 12.Â Remember to put it in the calculator as .005% / 12 which gives us .0004166%.Â That is our monthly interest rate.Â Multiply that number by the amount that is in your savings or CD.Â $10,000 X .0004166% = $4.17.Â That is how much you will make in a month.Â Now the next month you would include the previous monthâ€™s interest in with your principal balance, and would earn interest on that interest.Â This is called compounding interest, and can really help when you save a lot of month.Â

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**Interest on your Loan**

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Now here is how interest rates are charged on most loans.Â Compounding works against you when you are paying a loan.

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**The Bad**

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The same way that compounding interest can help you when you save money, it can hurt you when you borrow money.Â Have you ever multiplied your monthly mortgage payment by the number of months left?

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*Home Purchased for $150k – 30yr 4.5% Mortgage Payment $760/mo â€“ 760 X 360 = Â $273,600Â*

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The result is a number much more than you purchased your house for.Â The reason is compounding interest.Â The bank compounds the interest charge that you pay on a monthly basis.Â The interest rate is calculated based off of the principal balance that you.Â In order to calculate this, itâ€™s the same formula as before.Â

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*Take the interest rate of 4.5% or .045% and divide it by 12 months which gives you .00375%.Â That is your monthly rate.Â Now times that by your principal balance of $150k and you get $562.50.Â Now take your mortgage payment of $760 and subtract the interest of %562.50 and you get $197.50.Â That is how much of your payment is going to reduce the principal balance.Â*

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It is important to understand how interest rates work in order to know just how much a purchase will cost you, or how much money you can make.Â Now that you know how to calculate interest rates, you can become a smarter spender and hopefully make more intelligent financial decisions.Â